We have many reasons to believe U.S. inflation will remain elevated for several more years, and stocks may be your best option for long-term savings.
During the 1990s and 2000s, the average annual increase in the consumer price index was about 2%. Americans benefited from the digital revolution. Vast improvements in computing power, and easier access to software through the internet, cloud and smartphones boosted productivity.
Meanwhile, globalization and economic reforms brought China and smaller Asian economies into the West’s supply chain — cheap labor for inexpensive coffee tables and computers. Unemployment in the West was a chronic policy concern, but that kept wages and inflation down even in non-traded services.
Now, all of that has flipped. Artificial intelligence is replacing the internet as the driver of change, but ChatGPT poses quite different challenges. AI is tasked with replacing workers with complex skills and judgement and that will prove more difficult.
Declining birth rates and partisan squabbling about immigration reform have created skilled labor shortages. Expensive college degrees often don’t translate into marketable skills. All this creates wage pressures — and inflation.
Economic reforms made China prosperous but also dangerous to the world order. Shifting manufacturing to Vietnam, India, Mexico and other venues and reshoring semiconductor production is costly and inflationary.
Meeting the competing demands for a stronger military and social programs is driving up U.S. federal deficits. Those will force the Federal Reserve to choose between uncomfortably high interest rates or printing money to purchase the resulting debt.
Inflation in the U.S. more in the range of 3% to 4% than 2% is likely. As baseline inflation rises, so does volatility — spikes to 5% or 7% are more painful for consumers than spikes to 3%
All of this is tough on the aging U.S. population. For example, teacher pensions in Virginia are adjusted annually up to 3% for inflation. Above that, retirees hired before 2010 get half that rate up to 5%. Those hired afterwards receive a max of 3%. Many other defined benefit pensions pose similar issues, as do many annuities.
Most Americans don’t received defined benefits. They plan for retirement using tax-deferred accounts established by employers, or save through IRAs and similar vehicles. Historically, people have been advised to invest in equities according to the “100 minus your age” rule. If you’re 65, for example, that’s 35% stocks and 65% bonds.
Yet a spike in inflation and interest rates reduces the purchasing power of payments from existing bonds and the market value of those bonds for retirees who are gradually selling securities.
Higher inflation requires Americans to take more risk by investing larger shares in stocks— for example, an S&P 500
SPX
index fund. According a data base maintained at the NYU Stern School of Business, over the past 25 years, the average annualized return for the S&P 500 was 9.2%, while 10-year Treasurys returned 1.8% and home values added 5.3%
If you can own a home for about as much as you can rent, only buy as much house as you reasonably need. Otherwise, the money is better invested in equities. After all, you can’t sell bedrooms vacated by adult children one at a time as you need cash. Downsizing in real estate is costly — you’re on the hook for realtor fees, renovating the new home, relocation costs and renting storage space, among other expenses.
Bonds and other fixed-income instruments such as annuities provide ballast, but at the cost of eroding purchasing power. Over a 20-year retirement, losing 2% a year to inflation diminishes the redemption value of a bond by 33%, and at 3% inflation the hit is 45%.
Investing mostly in stocks and then gradually reducing your equity holdings to 50% over the 10 years prior to retirement appears to be the safest course. The more you save for retirement, the easier it is to endure the volatility of the stock market. If you enter retirement with half of your assets in stocks and half in 10-year Treasurys, the historical averages indicate an average annual return of about 5.5%. That should beat inflation.
Peter Morici is an economist and emeritus business professor at the University of Maryland, and a national columnist.
Also read: As you near retirement, scrutinize your Social Security statement. Here’s what catches an adviser’s eye.
More: Want great stock-market returns without great risk? It’s possible if you do these two things.
Read the full article here