The Four Layers Of Inflation

As we entered 2021, we put the pivot point of the economy and market returns squarely on inflation. An environment where inflation is elevated for a longer period dictates that changes to allocations are necessary. When the question is about concerns with inflation, there were two of the three answers that dominated the answers: “There is no inflation and we have heard this for 25 years with no elevated inflation occurring,” and “We are going to go back to hyperinflation of the 1970s and 1980s.” The least answered among most clients was that “We are in for elevated levels of inflation.” One can understand psychologically why the two polarizing answers dominates the debate; however, it quickly becomes apparent that most investors are not prepared for the more likely scenario based off recency and confirmation bias.

We will discuss as briefly as possible while touching on the more salient points of the inflationary cycle and the layers and sequencing that are at play.

The four layers of inflation are – and by no means every form – asset, input, wage and ultimately consumer pass through.

Asset inflation is by far the most prominently felt at this stage of the recovery and doesn’t need much belaboring at this point. As we look at elevated multiples and exuberant enthusiasm for equities, it is not a surprise that the cannibalizing of future growth in many sectors has confused many investors as to where we stand in the economic, credit and market cycles. Equity multiples and prices combined with historic low spreads on high yield debt and investment-grade credit would dictate we are in a late stage cycle. Earnings growth, however, points to early cycle metrics and the worst start to fixed income returns could lead one to believe we are in the mid stages. If we remove these metrics, the mere aspect of time (months after the worst of the recession) would warrant an early cycle. Lastly, some of the inflation metrics would dictate a later stage cycle. All this is to say that certain historical road maps are not as clean as Economic engineers would like. There is far more need for an artistic scrutiny than a scientific one, as much school yard as classroom if you will.