Rising Inflation and Your Portfolio

October 14, 2021

• Inflation is rising, leading to questions around portfolio positioning.
• Past bouts of inflation were not necessarily bad for stocks and bonds.
• Hedging inflation can be challenging. Diversification is still key to managing inflation.

You have probably been hearing a lot about inflation recently and likely even experienced it firsthand. If you have been looking to buy a car or book a hotel, you really understand. You may have even noticed price increases at the supermarket or gas station. At the supermarket, the largest increases over the past twelve months were for meats, poultry, fish and eggs. Beef, in particular, is up 17.6% over the past 12 months. These price increases hit our pocketbooks and squeeze our finances.

A common question we are hearing is, “what can we do about inflation within our portfolios?” It is a great question and a complicated one. Let’s start by looking at inflation and market returns over the years. If we go back to 1950, there were 32 years when inflation was above 3%. Stock market returns for these years averaged over 10% and bond returns averaged 7.5%. If we adjust for inflation, returns were still positive. However, the magnitude of the inflation is important. Modest bouts of inflation can be good for corporate earnings because it gives companies the opportunity to raise prices, something they have been struggling to do in recent years. So, if we look back at periods of inflation over 6%, stock and bond returns both averaged over 4%, but were negative after adjusting for inflation.

Looking at historical data doesn’t tell us the whole picture though. Historical bond returns are a good example. Currently, bond yields are low and expected to rise. The average bond returns shown in the table above seem out of reach right now. Bond prices rise when bond yields fall. Bond yields have fallen for decades and are poised to finally rise. There are factors that caused these market returns other than just inflation. Inflation is only one factor and maybe not even the right factor. Economists will tell us that “unexpected” inflation is what really matters. Let’s try to stay out of the weeds though and focus on some other variables. Economic growth (or “unexpected” economic growth) is a large factor that can impact markets as it relates to corporate earnings. Additionally, there are large global factors that impacted these returns in the past, ones that are unique to these periods of time. Since 1950, we experienced the Vietnam War, Federal Reserve policy mistakes, US Dollar depreciation from exiting the gold standard, and the 1973 oil crisis to name a few.

So, the reason inflation is rising could also be important, not just merely that inflation is rising. To complicate matters, the Federal Reserve is watching inflation more closely than anyone. Their actions can throw a wrench into the best analysis, because they can tighten financial conditions and, theoretically, squash inflation. For what it’s worth, the Fed projects core inflation easing to less than 3% next year, which would indicate this current bout of inflation is transitory. If not, the Fed will likely be more aggressive with tightening than what they are currently indicating. We created a Fed Monitor to project these developments.

Hedging the risk of inflation is also difficult. Surprisingly, gold is not always a good hedge, and Treasury Inflation Protection Securities (TIPS) tend to have long durations and may struggle if bond yields rise. While neither of these should be shunned, it is just a good example that hedging inflation is difficult and one single strategy to hedge inflation may not always work. With that said, some potential ways to benefit from inflation in a portfolio include an allocation to cyclical companies that could possibly raise prices to offset their rising costs or benefit from potentially higher bond yields. These might include companies from classic value sectors such as Industrials, Materials, Energy and Financials. Also, international equities could benefit if the U.S. dollar declines. On the fixed income side, it is difficult to hedge as we noted above, but a safer suggestion is to lower duration, or interest rate sensitivity, by investing in bonds with shorter maturities. As bond yields rise, one can then shift into bonds with higher yields.

We have been warning about the growing risks in the market, including inflation. Economic growth is slowing from very high rates, equity valuations are high, the pace of earnings growth is projected to ease next year, fiscal stimulus is fading, and the Federal Reserve will soon start tightening financial conditions. We expect volatility to rise in the near term. Timing the market or inflation is not advised as people tend to lose more money timing the market than focusing on long-term risk and return goals. We maintain that diversification is the key in this market. One should not put all their nest eggs in one basket, expecting one outcome. In these times, your financial professional can help you stay focused on your long-term risk and return goals and help you with your personalized investment objectives.

This report is created by Cetera Investment Management LLC. For more insights and information from the team, follow @CeteraIM on Twitter.

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