Market Overview
Inflation is coming
Have you watched The Queen’s Gambit yet? If not, stop reading this, fire up Netflix and binge for the next seven hours. We’ll wait.
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There. Aren’t you glad you did that?
Not that we needed one, but we did have a reason for suggesting this miniseries specifically. It reminds us how many pieces there are to the investment chess board, how they all move in a unique manner, and how you as a player need to understand how they can be orchestrated into one, successful strategy. It’s not easy.
And, like a pesky knight zigzagging across the board to give your opponent control of the center, inflation has advanced from its obscure origin point to threaten your higher-value pieces.
Now, imagine if Anya Taylor-Joy as Beth Harmon were a fund manager. Credit: Flitcraft Ltd., Wonderful Films
The dollar will shrink, but by how much?
As we noted above in the Market Outlook, the greenback’s value has eroded when compared to other currencies’, so goods coming in from overseas have become increasingly more expensive in dollar terms. But will this inflationary trend continue?
The US dollar’s recent slide isn’t the only reason to expect more inflation in 2021. Historically, pandemics have generally led to inflation because a) there’s typically a lot of rebuilding to do and b) there are fewer skilled tradespeople left to do that work. As that labor demand exceeds supply, wages go up and, as a result, so do prices.
And yet none of this has happened yet. In fact, 2020’s inflation rate was barely half that of 2019’s. But this is a new year, and expectations are for higher inflation going forward. However, that doesn’t necessarily mean much higher inflation. The Labor Department’s most aggressive estimate is still short of 4% annualized for 2021.
When you consider that this takes into account the lower foreign exchange value of the dollar, expected wage inflation and, of course, the trillions of dollars of response and relief money being pumped into the economy, that figure is actually pretty low.
Interest rates rising
But there’s one other piece that’s moving against us on the chessboard: interest rates.
“When a country raises the yield on its bonds, then it is in essence paying people more money to hold on to them risk-free,” we wrote last year. “Money from abroad pours in to buy these bonds, or to be deposited in local banks which are now offering higher rates on deposits. This generates new demand for the local currency, which leads to a higher price for it.”
That’s starting to happen now. For quite some time, the Federal Reserve kept interest rates as low as possible, so businesses can spend less on borrowing costs and more on buying things and paying employees. As we pointed out in September, “this also means keeping money cheap. Of course, ‘cheap money’ is just another way of saying ‘inflation.’”
With Democrats on the verge of taking over the White House and both chambers of Congress, government spending is certain to increase. That means borrowing will go up, and that means Washington will have to pay higher interest rates. While this has the effect of keeping a lid on inflation, it also means that a larger proportion of tax dollars will be required to pay the interest on the debt. The benchmark 10-year U.S. Treasury note’s yield recently rose above a psychologically important barrier; the not-so-bad news, though, is that barrier is a paltry 1%.
So whether you’re in the middlegame stage of your investment game and trying to keep your king in relative safety, or whether you’re in the endgame and going in for the kill, you need to understand how all of the pieces are moving across the board. How far and how fast will inflation advance? Might you leave yourself open to higher interest rates while you’re guarding against inflation? This might be the perfect time to take a lesson from a financial grandmaster.
