Inflation is a major consideration when it comes to the performance of investment portfolios. Due to a convergence of different economic factors including scarcity of workers, pent-up demand and insufficient supply, inflation recently hit a 30-year-high.
The fear of inflation is not unmerited, as it can be challenging for investors and consumers alike to navigate a high-inflation market. However, diligent investors must focus their efforts on managing the risk to their portfolios to the best of their ability. By understanding the impact of inflation on stocks and bonds, as well as what sectors to watch and avoid, investors can proactively hedge against the impacts of inflation.
Inflation’s Impact on Stocks and Bonds
To best understand how to proactively manage a portfolio through high inflation, it’s key to understand the impact that it has on stocks and bonds.
Bonds are traditionally stable, low-risk and good hedges from the potential volatility of stocks. Unfortunately, the bond market does not do well with inflation. When inflation rises, the Federal Reserve will increase interest rates to decrease borrowing, driving the value of the dollar down even as the cost of goods rises and spending power drops. This causes bond yields (interest) to increase as investors demand compensation for inflation risk. Ultimately, the price of the bonds will drop as investors lose interest in it, lowering the value of your investment.
While this is not promising for the bond market, investors can look towards TIPS (Treasury Inflation-Protected Securities) bonds, which adjust the bond’s principal value based on inflation. Further, placing emphasis on other investments during this period is important.
While stocks are generally more volatile than bonds, they will more likely keep up with inflation. Because the market tends to be cyclical, diversified portfolios are usually equipped to handle inflation concerns. Many financial experts discourage rebalancing the portfolio during inflation, as long as one is already sufficiently diversified.
High inflation certainly puts a damper on bonds and stock returns. Don’t rush into a complete portfolio overhaul out of fear. Instead, diversify and rebalance your investments with slight overweighs to enhance portfolio performance.
Sectors To Watch
There are definitive sectors that are more likely to better manage inflationary risks, including tangible assets, commodities and inflation-protected bonds. Outside these sectors, a well-balanced portfolio is another good hedge.
Tangible assets focus mostly on real estate and real estate investment trusts. Inflation is beneficial to real estate investors for a few reasons: it acts as a discount to debt (increases equity), it increases rental income for investment property owners and it doesn’t negatively impact property values. If you don’t already own property, you can invest in REITs (real estate investment trusts), which also tend to produce value in high inflation environments.
Commodities are another inflation hedge. Because they are priced in U.S. dollars, it’s actually good for them as the dollar falls. Likewise, as commodity prices rise, so does the price of products that the commodity is used to produce.
As previously mentioned, TIPS bonds are a great way to maintain bond investments even during high inflation periods. While normal bonds are risky and face losses during inflation, TIPS will help hedge against it, as they were created to do.
Finally, a fundamental hedge strategy against inflation is a well-balanced portfolio. Focusing on a mix of 60% stocks and 40% bonds and cash will help manage inflation risk and provide long-term return potential. However, the concern is the loss of additional returns that could be received by betting on stocks. Therefore, this is a very conservative investment strategy that will not always hold up as well as rebalancing for different economic circumstances.
Sectors To Avoid
When it comes to avoiding investment areas, as addressed, traditional bonds are one area of concern. It is safe to presume that the Fed will raise interest rates, and the normally low-risk bond market will be affected. In particular, investors should avoid those bonds that are considered interest-rate sensitive.
In addition, investors should stay away from growth stocks. Growth stocks are defined as those with minimal cash flow today that will likely see gradual increases over time. These stocks stand in contrast to value stocks, which currently have strong cash flows that will decrease over time.
Based on discounted cash flow calculations and the presumption that interest rates will change, growth stocks are negatively impacted by high inflation, while value stocks are positively impacted. Consequently, investors should steer clear of growth stocks, given that their future cash flows will be affected by inflation today.
Assess Your Investment Strategy Now
The truth to high inflation is that it is a cyclical aspect of the economy. Investors should not try and time their investments based on market predictions, and rather persistently focus on overweighing certain sectors rather than overhauling their portfolio. Further, emphasizing specific sectors and avoiding others will help in rebalancing to offset inflation and manage risk to your portfolio.
Brian Menickella is a co-founder and managing partner at The Beacon Group of Companies, a broad-based financial services firm based in King of Prussia, PA.
This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Any economic forecasts set forth may not develop as predicted and are subject to change.