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Well, it’s finally here – the ‘I’ word is back. After threatening to poke its head out and mess with all of our financials, we are now in the state of ‘transitory inflation’. The term itself is menacing. Investors are concerned. Ideas are flying around, yet it is not clear what investors should do if anything.
What exactly is ‘transitory inflation’? Inflation is the progressive increase in prices for goods and services over time. Further if something is transitory, it could mean it isn’t permanent or that it lasts a short period of time. To give context, since 1926, the historical average inflation rate is 2.6%. Today it is trending closer to 5.4%.
Looking through this lens, investors are simply solving for how to manage their portfolios for what may be a very short period of time. When there are challenges in the marketplace, the best advice is to stick to your knitting. It’s boring, but it’s often the right move. An asset allocation strategy works because it is built to withstand all market cycles.
But just because that is the right advice, it doesn’t mean investors follow it. What investors really want is to do something – take some action.
There are a few moves investors can make right now that might alleviate their stress over inflation and manage the impact on the portfolio. One is strategic and two are more tactical in nature. These ‘hedges’ so to speak, can provide investors with some peace of mind in navigating the markets.
One is strategic and two are more tactical in nature. These ‘hedges’ so to speak, can provide investors with some peace of mind in navigating the markets.
Run Towards Equities and Away from Cash
Out of all the choices an investor needs to make in fighting inflation, perhaps the best advice is simply the easiest to follow. Stay invested in equities.
It is straightforward and pragmatic advice. A company facing rising costs, can simply offset them by raising prices, which raises revenue and earnings. A win for the company and the investor. It’s a perfect inflation hedge and is consistent with an asset allocation strategy.
Investors who are more anxious about inflation may want to allocate even a few percentage points more of their portfolio to equities to fight off these fears. Remember, we said this inflationary period is transitory; when prices stabilize, investors can simply peel back this excess allocation.
And one thing to remember is that this time around, with inflation, savings rates are also not rising as well. This is contrary to other periods of high inflation where savings rates also rose as interest rates increased. Being in the equity market allows an investor to pick up more return and over time will increase their purchasing power.
Tilt Towards Floating Rate
In a well-allocated portfolio, the bulk of the fixed income exposure should come from high credit quality bonds. However, in this market, fixed income returns have been flat to negative. For investors looking to fight off inflation, this seems like a losing battle.
There is one segment that may serve as a hedge. It’s called a floating rate bond fund. This investment can be added as a tactical tilt to a portfolio that can make all the difference in an inflationary environment. But investors need to understand how these funds work.
Typically, floating rate bonds are variable interest rate loans banks make to companies. In terms of credit quality, the loans are considered senior debt, which means that in the event of a company’s insolvency, it is higher up on the repayment schedule than other holdings such as high yield.
But these instruments are unique in a high inflationary environment because when inflation causes prices to rise, it also raises the interest on the bonds. Including a fund with these bonds in a portfolio can give investors a little bump to fight off some of the negative impact that inflation has on their other bond holdings. A tilt in the 1-3% range is sufficient.
Commodities Can Be a Help
The other tilt that investors can make is the tried-and-true commodities play. Commodity prices often go up in a period of inflation, so holding them allows investors to benefit from the demand for these assets.
Making an allocation to commodities really is about being diversified. A diversified commodities fund will mitigate some of the risk profile of this investment. And like the floating rate bonds, a tilt is more than sufficient to help as an inflationary hedge.
Inflation May or May Not Be Transitory
Americans have been fortunate to be in a low inflationary market for some years, due to technology, globalization and reduced inflationary expectations. But the Covid-19 pandemic has wreaked havoc.
As we go through this ‘transitory’ period, it’s important to stay focused on the components of portfolio construction. Staying invested is really the best thing an investor can do to weather the ups and downs of the current market.
