By Orhan Imer
After several years of low inflation - and concerns about the prospect of deflation - portfolios now need to be prepared for rising prices.
If you've ignored the risk of inflation over the past few years, you may need to change your approach. Since the summer of 2016, the headline rate of inflation (including food and energy) has moved steadily upward. In the span of just three months, starting in August, it rose from 0.83% to 1.64%. That trend is expected to continue through the spring, with inflation peaking around 2.4% by the end of Q1 2017. While the final percentages may skew higher or lower depending on a range of factors, it's clear that inflation will affect the investment landscape. Since rising inflation can erode the real value of assets and income, it's best to prepare your portfolios to protect against it.
Bond market signs point toward inflation and growth
Inflation is a particularly important metric for bond investors, given that most of the bond market is based on fixed rates. The main exceptions are inflation-indexed bonds like Treasury inflation-protected securities (TIPS), which have a portion of their return tied to inflation.
Signs from the market suggest that bond investors are now expecting inflation to rise in the future. David Kennedy, a Columbia Threadneedle fixed-income portfolio manager, has seen this in the yield curve, which has been getting steeper for bonds with longer maturities, and real rates (the spread between the fixed nominal rate and the rate of inflation), which are also rising. In effect, the bond market is reflecting expectations for both inflation and growth.
Include inflation-resilient assets in your portfolios
From a multi-asset-class investment perspective, the aim should be to include securities in your portfolios that will respond positively if the inflation trend continues. Some inflation-resilient assets, such as TIPS and commodities, have historically done well in this sort of environment, and investors should be looking to diversify by adding exposure to these asset classes.
There are a few issues to bear in mind with these assets. The value of TIPS decreases when interest rates rise, and commodities can be a volatile asset class. It's also possible to gain exposure to commodities by buying other international assets, such as equities from commodity-exporting countries (e.g., Australia or Brazil).
The benefits of diversification
There are other inflation-resilient options beyond TIPS and commodities, but the performance of other asset classes during inflationary environments has varied widely in the past. The most obvious risk is with cash, which loses value steadily as prices rise. Research has shown that gold can sometimes act as a hedge against inflation, but it can also underperform during periods of rising inflation. Real estate investment trusts (REITs) and other related real estate investments have tended to do better, but their performance is subject to many other factors and there is no guarantee they will do well this time.
A 2009 study by the International Monetary Fund found that over a 12-to-18-month period with inflation shocks commodities were the best-performing asset class, bonds were the worst and equities suffered the most short-term losses that failed to recover over the longer term. However, more recent research from the London Business School found that equities have done well when inflation is within a low-to-mid-single-digit range. The mixed performance of different asset classes during past periods of inflation is a strong argument in favor of diversification this time around.
The Fed and Trump: Inflationary forces
The likelihood that inflation will continue to rise is driven by a policy shift at the Federal Reserve that is less accommodating and the uncertain fiscal and tax-reform platform of the Trump administration.
The Fed appears to be comfortable with higher inflation and has indicated that it wants to run the economy "hot." During a mid-October speech in Boston, Federal Reserve Board Chair Janet Yellen spoke about "temporarily running a 'high-pressure economy,' with robust aggregate demand and a tight labor market."
Though Yellen has since backed away from her statement, the Fed is unlikely to implement measures that could kill inflation, such as a rapid series of rate increases. This makes sense given that the Fed believes there are still productivity gains to be made in the U.S. economy and that the market has fallen short of the Fed's 2% inflation target for some time now.
The uncertain fiscal and tax-reform platform policy positions of the incoming White House team also seem likely to support inflation on the margins. Donald Trump has put forward a set of ideas that may involve higher fiscal deficits, a large infrastructure build-out and protectionist trade policies, all of which could support higher inflation.
The combination of Fed and Trump policies leads us to think the current inflationary trend is likely to continue for some time. Inflation has been so low for so long that it has, to some extent, been ignored as a risk factor. People were resigned to a world of low growth and low inflation. That looks set to change, and you should prepare now to adapt to this dynamic environment.
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