It’s been a long time since we’ve had significant inflation in the US economy. But as a near-Boomer, I can certainly remember when we did. In the early 1980s, inflation spiked to nearly 15%, and 30-year mortgage rates topped 18%. (I was lucky enough to have one of those loans on my first house.)
With inflation that hot, consumers and businesses actually altered their spending habits, because to wait to buy was to pay more. As prices seemed to go up by the minute, households would fill up their gas tanks more frequently, overstock their kitchen pantries and second freezers, and buy big-ticket items sooner than they planned. Businesses made large investments in factories and equipment ahead of when they needed to.
And all the extra consumer spending and business investment during periods of inflation often cause more inflation, creating a nasty feedback loop of “inflationary expectations” that is difficult for the Federal Reserve to bring under control.
Fast forward to today. Many people working and investing now have no experience with high inflation and so may be overly complacent in watching for, and preparing for, its return. Yet it will likely arrive again—maybe soon. With this in mind, I’d like to share three ways to adjust your investment portfolio to prepare for a potential bout of higher inflation.
First, some context. Price inflation, or simply “inflation,” is defined as a general increase in prices of goods and services and a fall in the purchasing value of money. Inflation is most commonly measured by changes in the Consumer Price Index, a statistic reported monthly by the US Bureau of Labor Statistics.
Inflation has been under control in the US since the late 1990s, with year-over-year increases in prices running in a low 1% to 3% range. However, recent data shows cause for concern. The Consumer Price Index increased at an annual rate of 5% in May 2021, after increasing at an annual rate of 4.2% in April 2021, well above the 2.3% increase for all of 2019, before the pandemic.
So what is happening?
To combat the pandemic and resulting recession, the US federal government has pumped over $5 trillion (that’s five million multiplied by one million) into the economy, borrowing most of that amount and raising the national debt to its highest level ever.
In addition, the Federal Reserve has purchased assets (bonds) and made loans worth about $3 trillion during the pandemic in an effort to keep long-term interest rates low, while also holding short-term interest rates near 0%. This level of stimulus is unprecedented. Historically, high levels of stimulus have been associated with increases in inflation.
And yet, the Federal Reserve’s largest-in-history-to-that-point-in-time intervention during the Great Recession of 2008-09, which was about one-third the size of the current pandemic intervention, did not lead to higher inflation as many expected. Economists are unclear why higher inflation did not result, but it likely has to do with increased globalization, technology, and other deflationary trends in the global economy.
Coming out of the pandemic, many economists are expecting a short-term bump in inflation, lasting through the end of 2021, due to strong demand and recovering suppliers still struggling to produce enough goods and services.
Stock and bonds markets appear to be accepting the “transient inflation” hypothesis for now. But as is often said about inflation, it is hard to get that genie back in the bottle—inflationary expectations can be hard to control once they get established. And this is definitely a unique situation. There is a lot of debate in economic and financial circles about whether we are on the verge of entering a period of sustained higher inflation.
While we can’t decisively predict what is coming, it may be prudent to review your investments and prepare for a likely short-term bout of higher inflation or an unexpected longer-term bout of moderate inflation in the US.
There are three main techniques for dealing with inflation in your liquid stocks and bonds portfolio:
Outrun inflation
Hedge against inflation
Compensate for inflation
Outrunning inflation
Over the long term, stocks typically have outrun inflation. Between 1926 and 2020, a dollar invested in US large company stocks returned 10.3% per year and grew to $10,937. In contrast, over that same time period, the Consumer Price Index grew by 2.9% per year (representing inflation of 2.9% per year) and was worth a little less than $15. Stocks outran inflation by nearly 7.5% per year. There is no magic here—with their normal, expected growth, stocks just tend to earn returns that are higher than inflation.
Of course, there have been periods of time when stocks did not outrun inflation. For example, during the period of 2000–2009, stocks lagged inflation by about 2.5%. But in general, we expect stocks to earn returns that are higher than inflation, which builds wealth and preserves purchasing power. Having the proper amount of stock in your portfolio, as required by your financial plan, is a key part of protecting your investments from inflation.
Hedging against inflation
Certain types of investments tend to increase in value when inflation is on the rise. These investments, such as real estate and commodities, are said to hedge the risk of inflation.
Real estate can be held in the form of publicly traded and private Real Estate Investment Trusts (REITs). REITs invest in many types of primarily commercial real estate, such as office buildings, industrial parks, self-storage, apartment complexes, shopping centers, medical facilities, and others. REITs provide a natural hedge against inflation because commercial real estate rents and property values have tended to increase when prices are moving up.
Similarly, commodity prices have tended to increase with the general level of price inflation in the economy and provide a hedge against inflation. Commodities are key inputs in the production of the many goods consumers and businesses purchase and include well-known precious metals such as gold and silver, two long-time favorites for hedging inflation, and also industrial metals such as copper, aluminum, zinc, and nickel, which are critical in many industries.
From the energy sector, oil, gasoline, and natural gas are important commodities. Agricultural commodities include corn, wheat, sugar, coffee, cattle, hogs, cotton, and lumber.
Compensating for inflation
Investments that compensate for inflation include securities that provide an adjustment mechanism. For example, the popular Treasury Inflation Protected Securities (TIPS) are bonds issued by the US government whose principal value increases with inflation as measured by the Consumer Price Index—the inflation adjustment is built in and automatic for investors. Other types of investments add inflation protection to corporate and municipal bonds to provide a “real return,” which is the after-inflation return.
Using TIPS and real-return bond funds in the safe, fixed income portion of your investment portfolio can help lessen inflation risk. Having inflation adjustment on your bonds can be important because bond performance does not typically outrun inflation the way stock performance does, and inflation needs to be explicitly compensated for.
In summary, there are a few ways you can help protect your investment portfolio from inflation:
Outrun inflation by earning the higher rates of return offered by stocks. Maintain the correct amount of equity for your situation, as determined by your financial plan.
Hedge against inflation by holding investments that go up in value when inflation is increasing. Consider adding real estate in the form of REITs and a broad-based commodity index fund that includes oil and gas; metals such as gold, silver, and copper; and agricultural commodities such as corn and lumber
Compensate for inflation by including TIPS and other real-return bond investments that provide a built-in inflation adjustment mechanism.
When a period of inflation hits, you’ll be glad you considered your readiness.
Parkworth Wealth Management provides holistic wealth management services including financial planning, equity compensation planning, investment management, tax planning, and others, on a fee-only basis and as a fiduciary, acting in clients’ best interests. For a review of your portfolio’s inflation readiness, schedule a complimentary consultation.
