Lexicon Financial Group Weekly Update

Monday, November 15, 2021

 

Upcoming Event

November 16, 2021: Before the Business Podcast, Episode 8: Adoniaa Beauty available on all major podcast platforms and online.

November 18, 2021: Before the Business Look and Learn event on Zoom with featured guest, Lisa Ridout of Lisa Ridout Exclusive Jewellery. We look forward to hearing Lisa share her story of making unique jewellery for almost 30 years.


Looking Back

Preliminary results were released earlier last week for the Michigan Consumer Sentiment Index. If you recall, the data that creates this index comes from surveys of actual consumers. Analysts were largely expecting consumer sentiment to improve over the last month, but the results went in the opposite direction. Consumer sentiment fell, largely due to the escalation of inflation and the belief that no credible solution has been proposed to resolve it. So yes, investment news this week was once again dominated by inflation concerns.

 

Looking In

Inflation can be a tricky thing to grasp. On the surface, it’s as simple as the price for goods and services increasing over time. In 1965, you could buy the original Ford Mustang for a whopping price of US$2,427. Today, the base Mustang is US$27,155. Trust me, I know it’s not *exactly* the same car, but assuming it was equivalent, this implies an annual price increase of about 4.4%. Central banks try to keep inflation for all goods and services in an annual range of between 1-3%.

But how does inflation impact the way people think about their investments? For family and foundation clients alike, consider an investment as a deferred purchase. You are saving or investing assets today for use down the road, for retirement, for estate purposes, or to fund a program or initiative.

In an inflationary environment, your future purchasing power is eroded -- it costs more tomorrow for the same thing you could buy today. If your investment returns exceed the rate of inflation, your investment can purchase more tomorrow than they would today. Consequently, growth of purchasing power requires a rate of return greater than the rate of inflation.

 

Looking Deep

But like many things in the investment world, there is some cyclicality to the relationship between interest rates and inflation. As we wrote before, central governments will often increase interest rates (a way of removing capital from the economy), which tends to lower inflation. Inflation and interest rates are considered “negatively” correlated since an increase in one is often followed by a decrease in the other.

The chart below shows the historic relationship between interest rates and inflation going back thirty years. You’ll notice that there are some periods where the federal fund rate in the US (a proxy for the current interest rate, the orange line) exceeds the rate of inflation (the blue line, as measured by the CPI index in the United States). In periods like this, conservative investors can outpace inflation by simply holding less-risky investment assets like US-government issued T-bills. In periods where inflation exceeds interest rates (the blue line is higher than the orange line), inflation erodes purchasing power from conservative investors.

Of course, past performance is not an indication of future returns; periods of interest rate outperformance have historically been followed by periods of underperformance.

 

In simpler terms, in periods where the interest rate is higher than inflation, investors can protect their purchasing power by investing in short-term government issued securities – T-bills. In other periods, an investment in T-bills alone will lose purchasing power. Unfortunately for conservative investors, that’s not the world we live in right now.

Today, the gap between the interest rate and inflation is wider than it has been in some time. We do expect this to normalize and reverse course. Interest rates will rise and inflation will fall. We just don’t know exactly when that will happen.

 

Further Reading

  1. Markets & Investing – Raymond James
  2. History Says Don't Panic About Inflation

 

The opinions expressed are those of Craig Swistun and not necessarily those of Raymond James Investment Counsel which is a subsidiary of Raymond James Ltd. Statistics and factual data and other information presented are from sources believed to be reliable but their accuracy cannot be guaranteed. It is furnished on the basis and understanding that Raymond James is to be under no liability whatsoever in respect thereof. It is for information purposes only and is not to be construed as an offer or solicitation for the sale or purchase of securities. Raymond James advisors are not tax advisors and we recommend that clients seek independent advice from a professional advisor on tax-related matters.

  1. U.S Inflation data provided by Factset for the period beginning March 1991 till September 2021 with data seasonally adjusted.
  2. U.S Interest data provided by Economic Research Division of Federal Reserve Bank of St. Louis for the period beginning January 1991 till August 2021.

 

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