One of the biggest debates right now in the financial world concerns inflation. How much of a risk does it represent? Is it transitory, or will it pass in a few months, as global supply chain bottlenecks ease and as more people in the U.S. get back to work after the pandemic? Most importantly, what does the threat of inflation mean for your investments and what can you do for inflation protection?
To get some perspective, let’s first look at the Federal Reserve.
Recently, Fed chairman Jerome Powell acknowledged that the pace of inflation was picking up. However, he also noted that the price of lumber, which has been a key data point relevant to the homebuilding and home remodeling boom, has dropped sharply since its peak in early May.
Powell cited lumber as an example of why inflation in other areas is likely to ease. Speaking before a Congressional panel in June, Powell said a situation where the U.S. would see hyperinflation similar to the late 1970s and early 1980s would be “very, very unlikely.”
“What we’re seeing now, we believe, is inflation in particular categories of goods and services that are being directly affected by this unique historical event that none of us have ever lived through before,” said Powell.
He noted that the current bout of inflation is due to “extremely strong demand for labor, goods and services” compounded by a “supply side caught a little bit flat-footed.”
While sticking to the view that the current rise in inflation is transitory, the Fed kept its benchmark overnight rate near zero, as expected. The central bank also suggested it may begin tapering its bond buying program in the foreseeable future.
Equities As Inflation Protection
Historically, equities, as a broad asset class, have been a proven method of inflation protection. That should be a key component of your financial plan and investment strategy, as you allocate your assets to generate the income you’ll need in the future.
Check your long-term allocations to be sure your holding in equities is sufficient to weather higher inflation, even if it’s just a slight rise.
Although readers may focus primarily on equities in their trading, it’s certainly possible that your long-term accounts may be too conservative to meet retirement goals. Believe it or not, I’ve seen this many times, when new clients signed up with my former advisory firm.
Often, qualified accounts, such as 401(k)s or Individual Retirement Accounts hold investments made years ago, and never changed. They may hold assets that are too conservative – or too risky – to achieve your income needs, given your time horizon.
You may want to consider increasing your allocation to equities in general. This has to be deliberate, however. It’s not simply a matter of loading up on additional U.S. sectors if you already have broad domestic exposure, for example.
Some advisors are currently increasing their allocation to international equities and real estate. Many analysts believe increases in earnings in these two asset classes will result in price appreciation, which would provide some moderate inflation protection.
Don’t Ignore Bonds or International Stocks
International is an asset class that many U.S. investors ignore. Fixed income is another. That’s understandable. Bonds don’t return as much as stocks, they don’t get the media coverage, and they are not as much fun to trade.
Historically, bonds have been used to mitigate the volatility of stocks, not so much for inflation protection. Yet, investors have not gotten a good return from bonds recently, making it very understandable why this asset class gets shoved to the side.
High-yield bonds, as the name suggests, generate greater yield than higher quality bonds. The tradeoff is higher volatility. Emerging-market debt is also riskier yet has potential to generate a higher return than a typical basket of investment-grade domestic corporate bonds.
With the Fed indicating that it is at least ready to consider rate increases over time, it’s important to keep your core bond portfolio focused on the short and intermediate durations, which historically are less sensitive to rate changes. That’s a way to take a defensive position as interest rates increase.
Other methods of inflation protection include investing in dividend stocks and ETFs, which provide income in any market cycle or environment. It’s true that many companies suspended or slashed their dividends as a precaution during the pandemic, but many of those are reinstating or increasing dividends again.
Alternative assets such as precious metals and commodities may also provide some inflation protection. Before jumping in and reshuffling your portfolio, be sure to understand whether your long-term allocation is designed to withstand various market conditions while generating the return you need. Once you’ve made that determination, you can begin optimizing your investments to protect against inflation, whether more transitory or more prolonged.
What steps are you taking to protect your portfolio from inflation?