“I think we do need to try to not just rely on the central bank to, in its wisdom, adjust interest rates, but allow for people to avoid being exposed to inflation risk.” & Robert J. Shiller, 1946 – present, American Nobel Laureate, economist, and best-selling author

WAYS TO STAY AHEAD OF INFLATION “Oh, the miserable and calamitous spectacle! May mine eyes never behold the like, who now saw above 10,000 houses all in one flame.” This is how prolific author and diarist John Evelyn described the Great Fire of London, which started in the early hours of September 2, 1666 on Pudding Lane in the bakery of Thomas Farriner (sometimes Farrinor or Farynor), baker to King Charles II.

Pudding Lane was (and still is) located near the London Bridge in the center of London, which at the time was the third largest city in the Western world, behind Paris and Constantinople (modern-day Istanbul).

In a city where open flames were used for heat and light, fires were such a common occurrence that when Lord Mayor Sir Thomas Bloodworth initially saw the flames, he allegedly was so unconcerned that he went back to bed. By the time he realized his mistake, it was too late. He will forever be remembered as ‘the man who did nothing, or very little’.

Dry weather and a strong easterly wind created the perfect conditions for the fire to spread quickly through the poorly built urban sprawl that consisted mainly of wooden pitched buildings, tightly packed together along very narrow streets. Efforts by bucket brigades armed with pails of water quickly failed as the conflagration raged uncontrollably.

It blazed for four days before it was finally extinguished on September 6th. By then it had destroyed 373 acres of London, including 13,200 houses, the Royal Exchange, St. Paul’s Cathedral and scores of public buildings. Amazingly, only six verified human casualties were recorded, but thousands of citizens found themselves homeless and financially ruined.

As anyone who lives in these drought-parched parts of our country knows, something that begins as a small fire can quickly turn into a devastating

inferno if it’s not properly dealt with. In the same way, a seemingly small issue in our economy can become a major problem with severe consequences if it’s not addressed properly.

One particular issue in terms of underappreciated risks that has flown under the radar of many investors is inflation.

Technically, inflation refers to a sustained increase in the general price level of goods and services in an economy. In other words, it is the gradual erosion of the purchasing power of your dollar – you will be able to buy less. When inflation is 2%, a basket of products that cost $100 today would cost $102 a year from now. Or as former baseball player Sam Ewing put it: ‘Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair’.

While inflation may not always be thought of in the most positive light,

economists generally agree that a little inflation at a consistent and predictable rate is needed to keep the economy growing at a healthy pace. Even though we haven’t experienced high inflation for several decades - the last bout of inflation in the U.S. was during the 1970s when annual inflation rates reached double digits – there are signs that inflationary pressures are building in the domestic economy.

Aside from Fed policymakers expressing concerns that rising inflation could be a sign that the economy is starting to overheat, particularly after the stimulus of the recently enacted tax cuts, traditional measures of inflation in the U.S. have steadily increased in recent months.

According to the Bureau of Labor Statistics, the Consumer Price Index (CPI) increased at a 2.8% annual rate in May, its fastest pace in six years.

The Producer Price Index (PPI) rose 3.1% in the 12 months through May, the largest advance since January 2012. Excluding food, energy and trade services, the so-called core PPI moved up 2.6% year-on-year in May due to increases in manufacturing, construction and transportation input costs. The Fed’s preferred inflation measure, the core Personal Consumption Expenditures (PCE) price index that excludes often volatile food and energy, rose 2% in May from a year earlier after consistently running below that mark since April 2012 (see top chart on this page). At 108 months and counting, the current economic expansion is now officially the country’s second longest on record, while the unemployment rate stands at an 18-year low of 3.8% and the pace of monthly job growth remains solid. Although current wage growth falls short of the 4% increases that are typical during periods of low unemployment, there are signs that they are finally starting to rise. Average hourly wages were up 2.7% in May from a year earlier. Investors should keep in mind that the sizable jump in annual wage growth in January to 2.9% from 2.5% spurred a widespread sell-off in financial markets over fears of higher inflation and more aggressive interest rate hikes by the Fed. That switch in market sentiment was a clear warning sign that higher inflation could adversely affect financial stability. Meanwhile consumers are paying more to fill-up at the gas pump as oil prices jumped to a 3 1/2-year high in the wake of a sharp decline in oil inventories. National home prices increased 6.9% year over year in April and are forecast to rise 5.3% over the next year. At the same time, the Associated General Contractors of America (AGC) reports that “the cost of all goods used in construction rose 8.8% from May 2017 to May 2018, the steepest annual increase in nearly seven years.” And then there are the escalating trade tensions created by the White House’s push for tariffs on imports, which is causing uncertainty for many businesses whose costs could rise if the plan is finalized. Given the

interconnected nature of the global economy, protectionist trade policies could have wide-ranging economic effects. They make imported goods costlier and, at least initially, nudge up costs for American consumers as manufacturers pass the higher costs along. Consider automobiles for example: the U.S. automotive industry accounts for about 15% of steel demand in the U.S. and nearly 38% of all aluminum, making them the second-largest consumer behind construction. Morningstar analysts estimate the levies will add about 1% (about $300) to the price of new vehicles. In hopes to avoid the EU’s retaliatory tariffs, iconic motorcycle manufacturer Harley-Davidson promptly announced plans to move some of its production overseas as it

stands to lose as much as $100 million a year. If the recent responses of nations like China, Canada or the EU are any indication, tensions are likely to escalate in the coming months and present a growing risk for the broader U.S. economy and investors. While this is unlikely to significantly alter the Fed’s policy of gradually raising short-term interest rates (for now), the central bank and investors need to be alert to the potential implications of a trade war on monetary policies, economic growth, and inflation. Those who have been worrying about inflation over the past decade must now feel like they waited for Godot. CPI and wage inflation have remained modest despite a nine-year U.S. economic expansion and an unemployment rate that has dropped below the Fed’s estimated ‘natural rate of unemployment’. After

numerous false starts, inflation readings over the past several months suggest however that it finally might be ready for a resurgence. Although it looks highly unlikely that inflation will return to the double-digit rates of the 1970s, which was a marked deviation from America’s historical peacetime pattern, investors need to be mindful that even moderate annual changes in the rate of inflation can have a big impact on their investment returns and purchasing power over time (see bottom chart on this page). This risk is even more significant for those who are retired or close to

retirement and rely on investment income as they are less likely to recoup losses in purchasing power due to shorter investment time horizons.

Even though there is nothing investors can do to avoid inflation, they can take steps to prepare for it. That starts with being proactive in establishing an investment strategy that will help manage the effects of inflation.

Historically, the performance of both stocks and bonds has suffered in rising inflation environments, making diversification beyond mainstream asset classes more important. Since no single asset class has consistently outperformed in every inflationary environment, incorporating a blend of assets that tend to move in lockstep with inflation may enhance portfolio diversification and help hedge inflation risk.

Investors might be able to mitigate inflation risks through a strategic allocation to a basket of inflation-resistant diversifiers that, on average, outperform when inflation is rising*, such as:

• Stocks As the chart on thispage shows (sourced fromFidelity), don’t abandonstocks! While P/E levels tendto decline and companies’profits get squeezed in aninflationary environment, forlong-term investors, stockshistorically have provided anexcellent hedge against rising prices. Hence, they shouldbe a core component of most diversified portfolios.• Commodities as a whole typically tend to increase inperiods of inflation and thus provide a good hedgeagainst the rising cost of living. Energy and corn tend toshow higher correlation to inflation than commodities likebase metals.• Commodity-producing equities Companies, such asthose in the energy, precious metals, agricultural andmaterials sectors, tend to benefit from the same trendsas commodities.• Gold has historically been viewed as a safe havenagainst a potential sharp rise in inflation. If your focus isdiversification, gold is not correlated to stocks, bonds orreal estate. However, the returns from gold appear tohave no clear relationship to inflation.• Real Estate Investment Trusts (REITs) Real estate is anatural inflation hedge that also tends to pay decentcurrent income, which can increase when prices rise.

REITs have typically performed well over the long-term in periods of rising interest rates and inflation. • Short-duration bonds Duration is a calculation thatmeasures a bond’s reaction to interest rate fluctuations.Short maturities make bonds less sensitive to inflationbecause investors can frequently roll them over at higherinterest rates when they mature. This helps keep up withshort-term inflation.• Treasury inflation-protected securities (TIPS) areTreasuries that pay a fixed interest rate for the life of thebond and whose principal is adjusted based on changesin the CPI, thus providing a hedge against rising inflation.Their biggest drawback is that they usually have relativelylong durations and thus exhibit greater interest-ratesensitivity.

• Corporate inflation-linkedsecurities (CIPS), the corporate twin of TIPS, are private-sector bonds that have a coupon rate that is indexed to inflation. As yields adjust monthly, they provide an income that responds rapidly to changes in inflation. These bonds are not issued in large volume, so they can be difficult to trade.

Investors have been burned by inflation before. Although there is no assurance that recent data will accurately signal a resurgence in prices, the risk remains that the prevailing small inflationary fire could turn into an inferno. Buying insurance before a storm can look silly at the time,

but when the storm actually comes it looks like a savvy move.

For our valued clients, Telos takes a proactive role in assessing and managing their exposure to rising inflation. Using our independent research and best judgment, we develop a clear understanding of current market conditions and determine whether owning inflation-resistant assets enhances the desired risk/return characteristics of their portfolio.

While inflation risk confronts every investor, everyone’s situation is unique, so there’s no one strategy that will work for all investors. Rather, inflation considerations need to be tailored to the individual investor. Working with an experienced financial advisor, such as Telos, can ease the process of selecting a strategic asset allocation that accounts for your specific circumstances, goals, and risk tolerance and is well positioned to navigate short-term volatilities, including inflation. JULY 2018

*All investments contain risk and may lose value. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors. There is no guarantee that these investment strategies will work under all market conditions.