First Quarter 2021 Market Review: Understanding the Impact of Inflation
Investors of all sizes embraced risk-taking as stock indexes saw gains in the first quarter of 2021. Market headlines featured GameStop’s surprising surge to nearly $350 per share due to online forum hype, as well as the $69 million auction of a non-fungible token attached to a digital image.
The S&P 500 index ended the first quarter up 5.8% and the Dow Jones Industrial Average was up 7.8%. Interest rates are still historically low, but the 10-year Treasury bond yield increased to 1.7% at quarter-end from 0.9% in early January. The 10-year bond yield (when rising) tends to signal that investors are feeling more confident. Yields rise to make bonds more appealing to buyers who start buying stocks, no longer feeling a need to play it safe.
Investor confidence and rising stock indexes was attributed to clarity around which party controlled the U.S. Senate after the Georgia runoff election along with the March 10 passage of a larger-than-expected third round of government stimulus. Investors also saw reason for hope on the coronavirus front, with the Covid-19 vaccine rollout picking up steam and the daily vaccination average at nearly 3 million by quarter-end.
Economists are now raising their expectations for a powerful recovery, revising from a more sluggish post-Covid rebound. With signs of a fast-recovering economy pumped up by around $5.3 trillion in stimulus, some investors are starting to wonder if inflation levels will be impacted. In fact, a recent study found that people are online searching the word “inflation” at a rapid rate, with a peak not seen since 2008.
Federal Reserve Chair Jerome Powell has said that inflation is likely to pick up as the economy recovers from the pandemic, but he believes it will be temporary. With inflation on the minds of investors, we thought it would be helpful to provide a reminder about what inflation is and how it can affect you and your investments.
What Is Inflation? Inflation is defined as an upward movement in the average level of prices. Each month, the Bureau of Labor Statistics releases a report called the Consumer Price Index (CPI) to track these fluctuations.
Understanding the Consumer Price Index. The CPI is developed based on information provided by families and individuals on purchases made in the following categories:
- Food and beverages
- Housing
- Apparel
- Transportation
- Medical care
- Recreation
- Education and communication
- Other groups and services
Investments and Inflation. Inflation can affect your dollars and investments in several ways. Most notably, it can influence your portfolio’s rate of return, the purchasing power of your dollars and the actions of the Federal Reserve.
- Rate of Return
Inflation can reduce what we call the real rate of return on investments. If an investment earned 6% over a 12-month period and inflation averaged about 1.5 % during that time, then it would mean the investment’s real rate of return would have been 4.5 %, not 6%.
- Purchasing Power
Purchasing power is the number of goods or services that one unit of money can buy. Inflation puts your purchasing power at risk by decreasing the number of goods or services you are able to purchase for one unit of money. When prices for goods and services inflate, a fixed amount of money has less buying power.
- The Federal Reserve
Inflation can influence the actions of the Federal Reserve. If the Fed wants to control inflation, it has several ways to reduce the amount of money in circulation, including setting the target federal funds rate (the interest rate banks charge other banks for overnight loans). The federal funds rate indirectly influences other interest rates and it influences the stock market because an increase or decrease in interest rates can correspondingly increase or decrease borrowing costs for companies (and stimulate/de-stimulate growth).
With trillions of stimulus dollars injected into the economy, it’s no wonder investors are curious about the rate of inflation. As you likely know, the advisors at Charter Oak consider inflationary factors when constructing and rebalancing our clients’ portfolios and their financial plans.
We balance the allocation to stocks for growth and as a protection against inflation, alongside the allocation to bonds for preservation of capital. We also consider the upward or downward direction of interest rates when deciding the allocation to bonds (bond values fall as interest rates rise, and vice-versa). Finally, we adjust the average rate of return in our client’s financial plan by the average rate of inflation, to come up with a projected real return needed for a financial plan to be successful.
The advisors at Charter Oak welcome your further questions on inflation and how it relates to your investments and financial plan. And, on a lighter note, we have been so thrilled to hear your numerous stories of post-vaccination reunions with friends and family. We wish you many bright and sunny days ahead in spring and early summer 2021.
