Confidence Without Certainty
“No amount of sophistication is going to allay the fact that all your knowledge is about the past and all your decisions are about the future.” – Ian H. Wilson, former GE executive
Uncertainty, or risk, isn’t a bad thing. It is simply the reality that any given situation has more than one potential outcome, both favorable and unfavorable. One might argue it’s a defining characteristic of the future, and it most certainly is a necessary ingredient for making money in financial markets. To wit, if I offered to flip a known two-headed coin and asked how much you’d pay me if it came up heads, your response would (I hope!) be to tell me to take a hike. However, if I flip a fair coin with two potential outcomes, now we have the basis for a proper wager based on the odds (50/50). Clearly a simple example and most situations in life and financial markets are much more complex with many more potential outcomes, but hopefully the point comes through.
Simply put, as participants in life and financial markets we must abide in, dare I say embrace, uncertainty. And boy does the world offer plenty. I’ll spare us the laundry list, and rather focus on one that is prominent today though perhaps not well understood: inflation.
Though complex in its causes and effects, inflation is simply an increase in the aggregate prices we pay for things we need and want in life. Or said another way, it’s a reduction in the purchasing power of any given amount of money. Generally speaking, a steady and modest amount of it is thought to be good—the Federal Reserve, our central bank in the U.S., targets 2% per year as a mandate—too much or too little is thought to be bad. At a minimum, over time we want our income and investments to keep up with inflation so we can maintain or improve our ability to purchase the things we need and want in life.
If you’ve personally experienced a time where an unhealthy level of inflation negatively impacted your quality of life, you are likely over 50 years old or you lived outside the United States when it happened. That’s because we haven’t had a serious issue related to high inflation in the U.S. since the period from the early 1970s to early 1980s, when annual inflation ranged from 5% to 15%. And this is the only prior episode witnessed in our lifetimes. For that reason, it’s an element of financial risk that’s long been dormant and is little understood. That doesn’t mean it isn’t important to consider.
Detailing the potential causes of inflation and their interplay is beyond the scope of this letter, but suffice to say we believe the ingredients are present. Massive economic stimulus through government spending and monetary policy tools (low interest rate policy, money creation, and bond buying) in response to Covid—and the global financial crisis of 2008-2009 before that—has created a stronger economy, tighter labor market, and more demand for goods/services than would’ve otherwise been. We also have seen supply issues in products (food, cars, etc.), services, and labor related to an uneven reopening of the economy after Covid-related shutdowns. This combination of factors (higher demand + limited supply) has traditionally fueled higher prices. Do you feel/see higher prices in your day to day? We’re guessing you do, and the recent reported economic statistics are showing it too. The big debate seems to be whether the price increases are temporary or here to stay, which remains to be seen.
Thus far, the evidence from financial markets—as reflected in the prices of stocks, bonds, and real estate—suggests that these inflationary pressures are viewed as temporary by the majority of market participants. If longer-term inflation expectations take root, we should expect interest rates to move substantially higher than the current low levels. In this event, it is reasonable to expect a period of negative valuation adjustment across financial assets since the level of interest rates is a fundamental underpinning for all asset pricing. While we never quite know what will produce the next correction or bear market, we accept them as an occasional market reality, and this inflation risk factor is as prominent as any we face today in our view.
Lest all this talk of inflation be producing an unsettled feeling, let’s go back to where we began. Risk or uncertainty is unavoidable in life and markets, and in fact it is the necessary ingredient for us to earn investment returns over time. Our job, in partnership with you, is to ensure that we keep this risk and uncertainty at an acceptable level based on your particular circumstances and appetite. One that’s appropriately focused on the long game, keeps you moving toward your goals, and avoids the true risk of permanent losses that will keep you from winning in the long run. This is how we can maintain confidence without demanding certainty!
While we can’t avoid occasionally rocky times, please rest assured that we are working every day to build our investment portfolio to thrive in light of the long term opportunities and risks we see in the market, including inflation. Specifically, we’ve already positioned our clients’ bonds and fixed income to better withstand a potential increase in inflation and interest rates. We’ve also increased our exposure to hard assets like real estate and gold, which have traditionally been areas of relative strength in inflationary environments. And in our clients’ stock portfolio, we own companies that have what we view as a favorable combination of pricing power and reasonable valuations. This should protect and promote profits should inflation pick up and lessen the potential impact from the negative valuation adjustment we previously mentioned.
On the planning front, we’re still keeping a close eye on potential tax changes being considered at both the federal and state level. Specifically, we’re focused on potential increases in corporate tax rates, taxes on long-term capital gains, and estate-related taxes. Our planning team posted an update on that front in late July and it’s a fluid situation we’re closely monitoring. In inflation-related news, the team just posted this week about a significant recent nearly 6% bump in Social Security benefits for cost-of-living adjustment, the highest such increase since 1982.
Like we mentioned in our last quarterly letter, we’re profoundly grateful for the opportunity in helping clients walk through many of life’s big decisions and transitions including business sales, generational wealth transfer, retirement, caring for family, and charitable giving. Please don’t hesitate to let us know if there are ways we can help you or your friends; we’d love to be an advocate for your and their long-term flourishing.
With optimism,
Dustin
