Our Viewpoint: Rising Inflation and Your Portfolio
- 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. There is no silver bullet.
- 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. 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, but a complicated one. Hedging the risk of inflation within a portfolio is difficult due to the everchanging financial landscape. In short, there is no silver bullet.
Let’s look at inflation and market returns in the past. Since 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%. After adjusting for inflation, returns were still positive. But the magnitude of the inflation is an important consideration. 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. However, the periods when inflation was over 6% caused stock and bond returns to be negative after adjusting for inflation (see chart).
It’s important to realize this historical data doesn’t tell us the whole picture. Bond yields, for example, are currently much lower than the average bond returns over this period. Bond yields have fallen for decades and are poised to finally rise. And the Federal Reserve is watching inflation more closely than anyone. Their actions can change the financial landscape 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 (vs. > 5% today), 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.
So, what can we do for your portfolio? 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 these shouldn’t necessarily be shunned, we suggest 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. We utilize a tilt to value vs. growth as a result. Also, international equities could benefit if the U.S. dollar declines, which is why we diversify our portfolios globally. On the fixed income side, it is difficult to hedge as we noted above, but a safer suggestion is to invest in bonds with shorter maturities. As bond yields rise, one can then shift into bonds with higher yields. This is exactly what we do in your portfolio.
We do not try to time the market relative to inflation or otherwise. People tend to lose more money when they try. Instead, we focus on long-term risk and return goals. We maintain that diversification is the key in this market.
A diversified portfolio does not assure a profit or protect against loss in a declining market.