Despite Federal Reserve Chairman Jerome Powell’s recent prediction of a cooling in rising consumer prices early next year, we believe investors should begin preparing for long-term inflation risks. The Federal Reserve has already communicated that it is considering decelerating monthly bond purchases that started during the pandemic, following interest rate hikes, if necessary.
Just how effective this jawboning will be amid surging commodity prices and an ongoing labor shortage remains to be seen. Persistent inflation, which is what we expect in the coming years, will not bode well for many investors, especially those with portfolios heavily weighted toward bonds.
Why Inflation Matters to Investors
Reflation (an economic environment characterized by rising prices of consumer goods and rising wages in response to fiscal and monetary stimulus) has been upon us for well over a year. It sometimes precedes the kind of elevated inflation that can only be stopped by central bank intervention. Should the Fed choose to raise interest rates that have hovered near zero since March 2020, the cost of borrowing would increase, resulting in a significant tightening of monetary policy. We believe this could result in a crash in the stock market and the housing market and throw the economy back into a recession.
With that said, we do not expect the Fed to tighten monetary policy sufficiently to contain inflation. Policymakers have communicated that they intend to pursue financially repressive policies to reduce the debt-to-GDP ratio. This means letting inflation run hot while capping interest rates at a very low rate. That way, debt levels increase more slowly because of low interest rates while GDP increases more quickly due to rising prices. Financial repression was implemented in the years after World War II when the debt-to-GDP ratio was similarly high, and it succeeded in bringing that ratio down to a 35-year low after several decades.
Without interest rates rising, the 10-year Treasury bond hit 1.6% recently. If inflation runs above 4% over the next five years, we believe the real (inflation-adjusted) yield will be worse than -2.5% annualized. For context, the Fed’s rate-setting committee forecasted an end-of-year inflation rate of 4.2% during its September 2021 meeting. This is clearly a harmful environment for bond returns, which are likely to generate negative real returns that result in a loss of purchasing power.
But it is also a harmful environment for many stocks.
Case in point: When prices for raw materials and energy (most notably oil) go up, it becomes more expensive for companies to produce and transport the goods that generate their revenues and profits. While some companies can pass on additional costs to consumers, thereby preserving their profit margins, others could struggle to maintain profit margins through inflationary periods. As a result, stock markets could experience heightened levels of volatility and lower share prices.
Moreover, investors holding cash will see the purchasing power of cash diminish as prices rise. After all, real returns (what investors can expect in return after inflation is factored in) from your standard savings account may already be negative.
So how do you protect assets against inflation?
How to Protect Your Portfolio From Inflation
Here are a few strategies we believe can help you withstand the adverse effects of inflation:
1. Be wary of bonds and other fixed-income investments. In general, investors should try to avoid committing capital to Treasury bonds and other investment-grade bonds when inflation is rising. The interest rates are generally not high enough to compensate investors for inflation risks, and bond prices will go down if and when interest rates rise again. Inflation-linked bonds such as TIPS, which are tied to the consumer price index in the U.S., could be a hedge against short-term inflation.
2. Look for stocks with pricing power. For equity investors interested in making money during inflation, or at least protecting capital during inflation, owning shares of companies that can pass on higher prices to their customers and that aren’t likely to experience operating margin compression can be effective. Similarly, shares of companies that have high fixed costs and low variable costs, minimal capital expenditure requirements, and low P/E multiples will generally offer greater returns and less downside risk when inflation is high.
3. Own an allocation in gold and real estate. Often touted as a hedge against inflation, gold can offer investors a way to gain exposure to rising commodity prices and a depreciating currency. Likewise, investments in real estate could prove beneficial — especially if investors can lock in a fixed-rate mortgage payment while long-term borrowing rates are still low.
The bottom line is that persistently high inflation — while not ideal for investors — is something you can prepare to handle. Given the mounting evidence that current price increases might not be as transitory as the Fed first predicted, now is an excellent time to talk to your financial advisor about how to protect your wealth in the months and years ahead.
If you’re looking for tips on building a portfolio that can deliver long-term returns as the investment environment changes, check out this post on value investing. To learn more about how Pekin Hardy Strauss can help guide your financial growth, schedule a free financial assessment today!
This article is prepared by Pekin Hardy Strauss, Inc. (“Pekin Hardy,” dba Pekin Hardy Strauss Wealth Management) for informational purposes only and is not intended as an offer or solicitation for business. The information and data in this article does not constitute legal, tax, accounting, investment, or other professional advice. The views expressed are those of the author(s) as of the date of publication of this article and are subject to change at any time due to changes in market or economic conditions. Pekin Hardy cannot assure that the strategies discussed herein will outperform any other investment strategy in the future.