The Rise in Core Inflation
Updated: Oct 14, 2022
What does the future look like?
As we suspected, core inflation has risen at a substantial rate that we have not seen in over 30 years. The core index the Federal Reserve uses for inflation increased by a factor of 3.6% last month, which is the highest rate we have seen since the early 1990s.
Why is this occurring?
The increase in Core inflation is occurring due to material shortages, disruptions in the supply chain, and labor increases. Additionally, the financial markets are up about 235 points today, which is unusual. Why is this? Well, many people in the markets and our economists expect that inflation will taper off after we get through these supply chain disruptions and the pandemic.
My concern, however, is that we are at a point in time where we have ultra-low interests rates and an equities market where our average earnings per share in stocks and bonds are at about two and a half times their historical rate. We have been at the peak of a market cycle for about ten years. Therefore, I am concerned about what potential inflation will do to the financial markets and what will happen when the federal reserve stops its buy-back program and looks to lower interest rates. We will see a significant decline in the equity market in the future when these events occur.
The longer that inflation runs, the greater the risks.
My advice to my clients is to diversify their portfolios and allocate their capital away from the equity market, so they have insulation against a major correction.
Where do we look in these times of uncertainty where there is potential inflation and where we have a peak equity market? We look at things that are counter correlated to the financial markets and perform exceptionally well in an inflationary environment.
There are about two-three asset classes that do exceptionally well.
Precious Metals - Precious metals have a place in client portfolios. However, the problem with precious metals is that you speculate. You only make money when the price of the metal increase. Additionally, precious metals don’t create cash flow. They do not generate an income.
Passive Residential Real Estate - What happens with this asset class in the inflationary environment? You see a significant increase in rental rates and a significant increase in the value of underlying assets in a single and multi-family portfolio. This is what we have experienced here at KeyCity Capital. We are a private equity company focused on workforce housing. We have seen a massive increase in rents and property valuation in our portfolio, predominantly located south of the Mason-Dixon line in landlord-friendly states. Most of our property portfolio is located in Texas and Florida. We have also been a big beneficiary of the Covid economy as the population shifts out of the upper northeast and upper midwest cities and even California to the Texas and Florida markets.
My recommendation is to responsibly take some capital out of the financial markets and allocate it into passive real estate because you will get very strong double-digit performance in that asset class.
Collateralized Debt Instruments - The other asset class that performs very well is collateralized debt instruments which are loans backed by some form of collateral. This asset class performs exceptionally well when we have inflation.
At KeyCity Capital, we have a lending fund designed to address weaknesses in a client’s fixed-income portfolio.
So, what is happening with the clients' fixed income portfolios?
Municipal bonds are getting called, and clients can’t earn a reasonable coupon on their capital deployed into corporate bonds or municipal bonds. Therefore, we have a lending strategy that allows us to earn high single-digit return rates in debt instruments with a significant form of collateral behind them.
The core index the Federal Reserve uses for inflation increased by a factor of 3.6% last month, which is the highest rate we have seen since the early 1990s.