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Investors are worried about the current state of the economy—namely, the
rising costs of goods on their savings. Each dollar buys less with every passing month of higher inflation, and savings are dwindling along with the “purchasing power” of what remains. This leads people to ask where to place their money at a time like this.

Although interest rate increases are terrible for borrowing money, they are great for your savings accounts. For the first time in over a decade, your normal savings could start earning reasonable risk-free interest if managed properly.

Before we discuss how to navigate the road ahead, let’s examine how we got to this point and the lessons learned from prior periods of higher inflation.

How We Got Here

In mid-2022, the United States experienced a surge in inflation, reaching a 40-year high. This upward price trend can be attributed to a supply-demand mismatch in which an excess of money is chasing fewer goods. Despite initial claims by the Federal Reserve that inflationary pressures were “transitory” and would diminish once factories and workers resumed normal operations post-COVID-19, supply chain shortages and subsequent spikes in energy and consumer goods have persisted.

The Consumer Price Index (CPI) measures the average cost of consumer goods and services. Fluctuations to the CPI reflect cost-of-living changes for households in the U.S. economy. The year-over-year increase in the CPI stood at 9.2% in May 2022, marking a historic high. The Federal Reserve, in response to this development, opted to increase interest rates as a defense against inflation, aiming to encourage consumers and businesses to reduce their spending by making borrowing more expensive. This measure is intended to bring inflation back down to the Fed’s long-term target of 2%. However, history has shown that achieving this goal is not an easy feat!

This is chiefly because inflation is a lagging indicator, meaning that it can only be measured after it has occurred. Therefore, interest rate hikes impact future prices of goods and services by slowing down the circulation of money in the economy. I once heard an analogy that likened it to steering an airplane that takes months to respond to any adjustment to the wheel. Certainly, this would make it challenging to time the next maneuver.

Lessons From Our Past

To examine what investors may experience next, let’s revisit lessons learned from prior periods of high inflation. Over the past 50 years, we have experienced inflation above 6% on three separate occasions (1973-1976, 1978-1982, early 1990, and we came close with inflation peaking at 5.37%, back in August of 2008).

While the events leading up to these periods differ, the economic pattern is similar. The Fed raised interest rates to combat inflation, which resulted in an inverted yield curve, where shorter-term bonds had higher yields than longer-term bonds. In turn, each of the three instances was followed by a recession, or a fall in GDP for two successive quarters.

Our economy looks very similar to the circumstance described above, as inflation is trending around 5% (as of early May 2023) and our yield curve is inverted. However, as of this writing, we have yet to hit the decline in GDP experienced in the prior three inflationary periods.

Although this may sound alarming, there are reasons for investors to be optimistic! The US stock market saw price declines in 2022 as investors fled from risky assets, which means equity valuations have already priced in the potential for a recession. Additionally, looking at prior recessionary periods, it’s important to note that not all recessions fall in lockstep with a bear market. For example, during the inflationary period of 1990, there was a recession but no bear market, and the economy recovered quickly.

Further, during the two periods of high inflation in the 70s and 80s, equity price declines began before the recessionary period, and the market started to recover before the economy exited the recession. This is, again, similar to our current circumstance in that the US economy, as measured by the S&P500, entered into a bear market in mid-2022 and has yet to recover. Which, if history is any indicator, may occur before we exit a period of GDP retraction.

Now, what about the bond market? There is hope here, too. After periods of high inflation, bond values tend to increase when interest rates decline. Interest rates are expected to decrease once inflation starts to track toward the Fed’s long-term target of 2%. A reduction in interest rates could follow if we enter a recessionary period.

In plain English, brighter days are ahead for high-quality bonds once interest rates decline, which is expected to happen by 2024 (as predicted by forward yields on treasury bonds).

Where Do We Go From Here?

The question remains: what investment strategy should investors deploy today? The answer depends on when you need to use the money. Investors should have short-, intermediate-, and long-term savings strategies.

For short-term monies (expected to be used in under two years), the primary goal should be to generate income and ensure safety. This means keeping minimal amounts of readily available cash for immediate needs because it loses value during periods of inflation and investing the remaining short-term money (within two years) into CDs and treasuries.

To this end, Whelan Financial introduced laddered short-term investments to fit a two-part client need:

  1. To increase income compared to excess cash held in a savings account
  2. To protect investor principal by using government-backed or FDIC-insured instruments

As of May 2023, short-term fixed-income instruments such as CDs and treasuries yield between 4.76 and 5.30% before taxes and if held for a year.

For intermediate-term money, or money you expect to use within seven years, investors should target high-quality bonds. These bonds are expected to benefit from price increases as inflation subsides and interest rates decline.

Lastly, when it comes to long-term money, or money you won’t use for at least seven years later, investors should utilize risky assets, such as stocks, to grow their money in excess of inflation.

As wealth managers, it’s our job to help investors put together an investment strategy in alignment with their financial goals. We create financial plans for wealth management clients to ensure future cash flow needs are met, an adequate withdrawal strategy is implemented, and these needs are complemented with a cogent investment strategy.

If you need expert advice in wealth management, please get in touch with us—one of our knowledgeable advisors will be happy to assist.

Authored by Taylor J. Whelan, CFP®

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