Tax Day & Inflation

At the end of today Tax Season is officially over.

This day, whether on April 15th or May 17th, holds some added significance for me — In 1980 (three years before I was born) my dad launched his accounting practice. I watched him navigate tax season after tax season over the years with 18-20 hour work days. The reprieve after April 15th was great. This is when we’d take family trips, shoot hoops in the driveway, etc…

He’s retired now and nothing gets in the way of shooting hoops with the grandkids, but I still feel a little sigh of relief when Tax Day has come and gone.

Although 2020 taxes are going to be in the rearview mirror, I’m looking forward to November/December this year when we have our Proactive Tax Planning meeting to see what can be done for 2021 and beyond. Within the current administration there have been a lot of rumblings of potential changes to capital gains taxes, income tax rates, investment real estate, etc… We’ll solve those problems when they show up, and the yearly tax planning meeting will help us.

Okay, onto the main topic of this blog: Inflation

In the last week or so we’ve been reminded of the potential for things we need (like fuel) to suddenly become significantly more expensive or completely unattainable.

While the cyberattack on a pipeline is a temporary supply shock, it may have you thinking about scarcity of things you need and whether or not inflation presents a risk to your future financial plan. As with anything finance-related, this is complicated — but I’m going to try and distill the situation down to a few actionable points.

Step 1: Defining Inflation

When considering inflation, the most commonly used term is CPI.

Per the Bureau of Labor Statistics:

The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. Indexes are available for the U.S. and various geographic areas. Average price data for select utility, automotive fuel, and food items are also available.

Over the last 12 months, CPI has risen 4.2%…. but energy has risen 25.1%

That’s a pretty wide dispersion between energy and everything else; and if we threw Housing on a chart like this it would creep up towards the inflation rate of energy.

The takeaway here should be that inflation affects each of us differently because the things we need are different. In the case of energy, a person who drives for a living is having a very difficult experience with inflation compared to someone who works from home.

So…. Step 2.

Step 2: Defining what inflation means to you

I really like the below chart and wanted to share it even though the data only runs through 2018…

You can see how different categories of goods have become more or less affordable over time.

This is where a financial plan comes into play….

Using the chart above, you can see that financial planning goals related to healthcare, college, or having kids have been harder to achieve, while your lifelong dream of having a wall full of televisions has never been easier to afford.

People usually come to me with some things they want to accomplish:

- Retire comfortably
- Send kids to school
- Give to causes they care about
- etc…

Within those goals there are often inflation considerations to make. As an example, part of “retiring comfortably” means having a plan to deal with the rising cost of health-related expenses; another part would consider the need for vehicle purchases in retirement, and so on.

Inflation affects each component differently.

So here’s where the first key tip for handling inflation comes in:

Tip: Need Less

Yesterday I saw an article highlighting the ultra-hot used car market (link) and real estate markets across the country are en fuego.

So how should you handle these circumstances? Well, first and foremost, you could try your hardest not to need to buy a car or real estate. Patience is power when it comes to being a consumer. Exercise your power if you can.

I know that sounds a bit simple; after all, financial advisors are supposed to recommend some product that outpaces inflation, right?

Wrong. My goal is to help pursue whatever your thing you want to accomplish.

Of course, some things are unavoidable and you have to buy them no matter what (healthcare, education, housing, etc.), but it’s worth building a financial plan that incorporates a flexible budget that is able to trim down how much you need to spend when the things we must buy get more expensive.

Step 3: The Best Defense is a Good Offense

The above chart shows the tremendous long term track record of capital markets compared to inflation dating back to 1926. Clearly the best long term hedges to inflation have been stocks.

However, when we think about inflation hedges, the first thing that often comes to mind is Gold. Because gold doesn’t have much utility, the key idea is that gold is a backup to fiat currency (USD) in the event that dollars become more worthless due to excess money printing by the the Treasury. I think this is a difficult argument to make and a few months back I outlined my position on gold and why I don’t broadly recommend it as an inflation hedge.

However, a lot of smart people believe gold has a place in a diversified portfolio… with “diversified” being the key point. You’ll have to make that determination yourself or with the help of your advisor.

In a related observation, this morning I received the below chart from TD Ameritrade’s Macro Monday (link). If inflation is here in 2021, some sectors are doing a better job than others at outpacing it.

There are a couple additional inflation-related strategies not listed above, but which are worth mentioning.

Inflation Linked Bonds (TIPS):
These securities are designed to keep pace with CPI. But again, if CPI is around 4.2% but you need to buy fuel or healthcare or a college degree, then the return on an inflation-linked bond may not be enough for you to hit your goal.

Series I Bonds:
What if you could get a very low risk 3.54% yield? I think most people would take it… After all, you’re getting paid like 93 cents to hold cash at your bank, right?

3.54% is what TreasuryDirect is paying right now on inflation-linked savings bonds.

But there’s a problem: the most you can buy is $10,000.

This means your annual yield on the deposit is about $354, which isn’t bad. But your financial plan is complicated and trying to squeeze an extra $354 out of your portfolio is not likely to change anything significantly.

A couple years back it was common to spread around funds to various high yield savings accounts to capture slightly higher yield even though there was a cap on deposits much like this $10,000 maximum investment.

I believe these smaller investments add more complexity than they’re often worth.

So here's what I’m encouraging you to consider…

Both TIPS and Series I bonds are pretty low risk — they’re defensive, they’re not too volatile, and the upside is fairly limited.

On the contrary, stocks and real estate are volatile and they can lose more frequently than TIPS and Series I bonds, but they have much higher upside potential and they can put your portfolio on offense.

Think about it this way:

You know you need “stuff” and that stuff is food, housing, etc. Once you have fulfilled your own need for stuff (a place to live, a pantry full of food, etc.) it can make some sense to own the entities which are constantly providing stuff to other people who need it. Yes, those entities have risks like the economy isn’t strong and people can’t afford this stuff anymore, or tax rates have gone up, so the profit margin we receive for selling this stuff isn’t as high, etc.

These risks, and others, materialize in both predictable and unpredictable ways. This is inherent in pursuit of the Equity Premium but it’s been a staple in long term capital market performance since the birth of the stock market.

No risk = no reward.

Conclusion

We can’t think of inflation as a single one dimensional thing.

It affects each of us differently based on what we want to accomplish, what we need, what we already own, and how comfortable we are adopting risk to combat it.

Much like health or money, inflation is a part of our lives that must be managed and understood. It’s a train that keeps moving regardless of how you feel about it.

If you want to dive further into the implications of inflation and how you’re positioned to deal with it going forward, please don’t hesitate to reach out.

Speaking of trains, below is my kid at the Railroad Park last week. Thankful to be through one of my busy seasons to be able to spend time with this guy. The future = bright.

If you have any questions, as always, let me know.

Onward,

Adam Harding | CFP | Advisor | Owner @ Harding Wealth Inc. | Smartvestor
Mobile Number: 480-205-1743

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