If one believed everything they read, you would think we are headed towards (or in) an inflation period like Venezuela’s or, for a less extreme example, the United States in the late 70’s and early 80’s (see table below for US Core CPI over the long term). Like many things, one needs to dig a little deeper to separate the wheat from the chaff. I don’t mean to underestimate the effects of inflation on anyone’s portfolio, particularly those on fixed incomes, but it is always good practice to keep things in perspective.
In the simplest terms, inflation is caused by too many dollars chasing too few goods and services. While economists’ debate whether the “Covid Recession” was created by a supply-shock or a demand-shock, or something in between; the reality is one would be hard-pressed to think we wouldn’t have some level of inflation as we began to exit the recession. As to the causes of inflation, some would argue supply chains aren’t functioning to capacity due to continuing issues with the labor market. Others argue that the level of support provided by the government (and the Federal Reserve) has caused the problem. The reality is – it is not a binary answer but rather a likely combination of multiple complex financial theories and behavioral changes. . Predicting inflation is no different than trying to predict the stock market, particularly in the short-term.
It is important to note that the United States inflation rate has been somewhat muted over the last few years and coming out of the recession one should expect inflation to rise given where we were last year at this time. The graph below charts the core inflation rate over the past 5 years.
If we look at rates over a longer period, we see “inflation cycles” in a similar manner to regular stock market cycles.
So, what does this mean for my investment portfolio? Inflation affects investment portfolios through an erosion of purchasing power over time. Think about what the cost of a movie was in your earlier years vs. today and you get the picture. A harder question to answer is what to do about it? Is there a way to “hedge” inflation risk?
One could argue that if financial markets reflect all available information, then markets have already priced in current inflation expectations and there isn’t really anything left to hedge… If that is the case, then what an investor is trying to hedge are unexpected increases in the inflation rate. To me, this seems to go back to the old question of market timing – when do I get in, and when is it safe to get out of a hedge position? I would argue that clients with a risk-appropriate, diversified investment portfolio should not be overly concerned with inflation risk. However, if one were really concerned and felt the need to do something, below are a couple of thoughts.
Equities – yup, good old-fashioned stocks provide a hedge against inflation as a company’s revenues generally adjust higher for increased prices. Additionally, assets like commodities and commodity producers are often cited as “safe havens” during inflationary periods – but let the buyer beware – commodities like metals, energy, etc. can be volatile! As mentioned before, similar to market-timing, you have to get 2 decisions right – when to buy, and when to sell.
For fixed income investors, inflation is a bit more problematic, but there are a couple of things to think about:
- Adding some exposure to Treasury Inflation-Protected Securities (TIPS) – these are securities where coupon and principal payments are tied to the inflation rate
- Shorten duration – bonds with shorter maturities are generally not as impacted by inflation as longer dated bonds
In closing, inflation risk is only one of several risks concerning to investors. Rather than trying to time the market, perhaps it may be best to review your portfolio with your advisor and ensure it continues to meet your short-term and long-term needs.