February 2025 Monthly Commentary

Inflation: Preparing, Not Predicting

By Rusty Vanneman, CFA, CMT, BFA, Chief Investment Strategist

• Inflation remains elevated. Recent data suggests that inflation is trending higher, with CPI, PPI, and consumer expectations all showing signs of persistence. While the Federal Reserve’s 2% target remains the goal, achieving it may take longer than anticipated.
• Inflation could rise or fall. Key drivers such as deglobalization, wage growth, and supply chain disruptions could push inflation higher, while increased productivity, lower energy prices, or a more aggressive Federal Reserve could bring it down.
• Investors should prepare, not predict. Diversification remains critical in navigating inflationary environments. Real assets, alternative strategies, and inflation-sensitive investments such as TIPS within fixed income portfolios can help build resilient portfolios.

By focusing on preparedness rather than predictions, investors may consider fortifying their portfolios regardless of inflation trends in the coming months.

Is Inflation Coming Back? 

Recent data suggests that inflation is not only still present but has been creeping higher in recent months. The idea that we’re smoothly trending toward the Fed’s 2% target may be premature. 

Consider the following:

• The January Consumer Price Index (CPI) came in above expectations, marking its biggest month-over-month increase since September 2022. Year over year, headline CPI is up 3%, while core CPI (excluding food and energy) is up 3.3%.
• Pre-pandemic, core CPI has not been this high since 1992!
• A key subset of CPI inflation — “supercore” inflation (excluding food, energy, goods, and housing rents) — rose 0.8% in January, its fastest monthly increase in a year. Over the past 12 months, it’s up 4.1%.
• The January Producer Price Index (PPI) rose 3.5% year-over-year, while core PPI climbed 3.6%. Over the past six months, annualized PPI inflation has been running at 4% — another indication of rising price pressures.
• Market-based inflation expectations (derived from the difference between inflation-linked bond yields and nominal Treasury yields) are back at multi-year highs across multiple periods.
• Consumer expectations for inflation have surged in recent months. The latest reading suggests consumers expect 4.3% inflation over the next year. While these surveys can be politically influenced, rising tariffs and surging egg prices (up more than 50% in the past year) may have played a role in driving up expectations.

Could Inflation Keep Rising?

It’s possible. Here’s why:

• Deglobalization trends (exacerbated by tariffs and trade tensions) could add to inflationary pressures.
• Federal deficits, historically a potential source of inflation, remain large.
• Supply shocks remain a risk given geopolitical uncertainty.
• Wage growth, which has lagged corporate profit margins, could drive sustained price increases.
• Decarbonization efforts could increase energy costs.
• Strong economic growth could sustain demand-side price pressures, especially if accompanied by lower taxes and reduced regulations.
• Historical precedent suggests inflation often comes in waves. The current cycle is starting to resemble past inflationary cycles, where an initial surge was followed by additional inflationary bursts.
• Expectations-driven inflation is a self-reinforcing cycle. If businesses and consumers expect higher inflation, they may adjust wages and prices accordingly, pushing inflation higher.

A few notes on tariffs and egg prices:

• Tariffs: While unlikely to be deflationary, as some suggest, tariffs are also not likely to be wildly inflationary. Conventional estimates suggest a 0.5% to 1.0% inflationary impact, although historical data suggests the effect may be smaller. Check out this podcast tutorial from The Inflation Guy on why tariffs might sometimes be positive and neither wildly inflationary nor deflationary.
• Egg prices: Egg prices have surged 14% in the past month, the second-fastest monthly increase this century (only June 2015 during the bird flu outbreak saw a higher increase). While some argue that this is a supply-driven “chicken issue” rather than an inflation problem, supply shocks like these contribute to broader inflationary pressures.

Could Inflation Fall?

It’s also possible. Here’s why:

• Productivity gains from AI and automation could help offset inflation.
• A more aggressive Federal Reserve could tighten policy if inflation and inflation expectations continue to rise.
• Lower energy prices (if supply increases) could ease inflationary pressures.
• A slowdown in economic growth could reduce demand-driven inflation pressures. Some early signs of economic cooling have emerged, but it’s too soon to tell whether they’ll develop into a broader trend.

Why Does Inflation Matter? 

Inflation impacts markets in several key ways:

• It increases volatility and complicates economic decision-making.
• It reduces real (inflation-adjusted) returns and corporate profits.
• It affects valuations — already at or near historic highs — which could create headwinds for both stocks and bonds.

For historical context, data from Orion’s OPS Reference Guide (as of Dec. 31, 2024) provides insight into how different inflation levels have historically affected corporate earnings growth.

• Below 3% inflation: The sweet spot. Corporate earnings growth has averaged 24%, with inflation-adjusted earnings growth of 21%.
• Between 3% and 5% inflation: Still a positive economic environment, but earnings growth tends to slow. This is where we are today. With market expectations high for both returns and earnings growth, any disappointment could weigh on equities.
• Above 5% inflation: A tougher environment. Historically, real earnings growth suffers significantly.
• Deflation? Even worse. While inflation can be a headwind, outright deflation tends to be more damaging for corporate profits and economic activity.

Stock market data from Yale Professor of Economics Robert Shiller.  As of 12/31/24.

How Can Investors Prepare? 

Building wealth requires investing, but diversification is key to constructing resilient portfolios.

To help fight inflation, these diversifying asset classes have historically helped multi-asset portfolios:

• Real assets, such as global infrastructure, real estate (REITs), natural resources, and commodities, tend to perform well in periods of above-average and rising inflation.
• Alternatives and diversified strategies have historically outperformed in inflationary environments and should be considered as part of a multi-asset portfolio.

A few notes on TIPS:

TIPS, or Treasury Inflation-Protected Securities, are inflation-linked bonds. That description leads many investors to assume they will perform well in an inflationary environment. The logic seems straightforward: If inflation rises, TIPS should generate positive returns. However, this expectation has often led to disappointment.

While TIPS can provide positive returns during inflationary periods, their performance is not guaranteed. A more accurate way to think about TIPS is as inflation neutral rather than a direct inflation hedge. Because they adjust with inflation, TIPS remove inflation risk but don’t necessarily produce strong absolute returns. In fact, a more fitting acronym might be TINS — Treasury Inflation-Neutral Securities — since they primarily protect against inflation erosion rather than capitalize on inflationary spikes. Meanwhile, nominal Treasury bonds effectively wager on inflation remaining stable or declining.

It’s also important to remember that TIPS are still bonds, meaning their pricing is influenced by interest rates. Factors such as term premiums (duration risk or interest-rate sensitivity) play a significant role. If interest rates rise sharply, TIPS can still decline in value despite their inflation protection. That said, in an inflationary environment, TIPS should generally be expected to outperform nominal Treasury bonds over time.

Bottom Line

Inflation is rising, but experts remain divided on whether it will continue its ascent or begin to cool. Either way, investors should be prepared rather than attempt to predict. Allocating to diversifying asset classes, particularly real assets and alternative strategies, remains a prudent approach. Not only does this make strategic long-term sense, but it’s particularly relevant in today’s uncertain environment.