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.
About Cetera® Investment Management
Cetera Investment Management LLC is an SEC registered investment adviser owned by Cetera Financial Group®. Cetera Investment Management provides market perspectives, portfolio guidance, model management, and other investment advice to its affiliated broker-dealers, dually registered broker-dealers and registered investment advisers.
About Cetera Financial Group®
“Cetera Financial Group” refers to the network of independent retail firms encompassing, among others, Cetera Advisors LLC, Cetera Advisor Networks LLC, Cetera Investment Services LLC (marketed as Cetera Financial Institutions or Cetera Investors), Cetera Financial Specialists LLC, and First Allied Securities, Inc. All firms are members FINRA / SIPC. Located at 200 N. Pacific Coast Highway, Suite 1200 El Segundo, CA 90245-5670
Individuals affiliated with Cetera firms are either Registered Representatives who offer only brokerage services and receive transaction-based compensation (commissions), Investment Adviser Representatives who offer only investment advisory services and receive fees based on assets, or both Registered Representatives and Investment Adviser Representatives, who can offer both types of services.
The material contained in this document was authored by and is the property of Cetera Investment Management LLC. Cetera Investment Management provides investment management and advisory services to a number of programs sponsored by affiliated and non-affiliated registered investment advisers. Your registered representative or investment adviser representative is not registered with Cetera Investment Management and did not take part in the creation of this material. He or she may not be able to offer Cetera Investment Management portfolio management services.
Nothing in this presentation should be construed as offering or disseminating specific investment, tax, or legal advice to any individual without the benefit of direct and specific consultation with an investment adviser representative authorized to offer Cetera Investment Management services. Information contained herein shall not constitute an offer or a solicitation of any services. Past performance is not a guarantee of future results.
For more information about Cetera Investment Management, please reference the Cetera Investment Management LLC Form ADV disclosure brochure and the disclosure brochure for the registered investment adviser your advisor is registered with. Please consult with your advisor for his or her specific firm registrations and programs available.
No independent analysis has been performed and the material should not be construed as investment advice. Investment decisions should not be based on this material since the information contained here is a singular update, and prudent investment decisions require the analysis of a much broader collection of facts and context. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The opinions expressed are as of the date published and may change without notice. Any forward-looking statements are based on assumptions, may not materialize, and are subject to revision.
All economic and performance information is historical and not indicative of future results. The market indices discussed are not actively managed. Investors cannot directly invest in unmanaged indices. Please consult your financial advisor for more information.
Additional risks are associated with international investing, such as currency fluctuations, political and economic
instability, and differences in accounting standards.
A diversified portfolio does not assure a profit or protect against loss in a declining market. Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing.