Inflation is suddenly a hot topic, but for many investors it seems like an empty threat—and understandably. The U.S. economy hasn’t seen serious price hikes since the 1970s. What about all those inflation fears following the financial crisis? In the end, inflation stayed below the Federal Reserve’s 2% target for more than a decade.
“For many investors, inflation was the boogeyman that never showed up,” says Tom Graff, head of fixed income at Brown Advisory, based in Baltimore.
But investors shouldn’t assume this will always be the case. In fact, for many reasons, strategists and advisors have been factoring inflation into their forecasts and overall portfolio recommendations. While few advocate taking drastic measures to hedge against rising prices, now is a good time for investors to get reacquainted with inflation and its implications.
Many Factors Signal Inflation
There are many reasons inflation could be around the corner, but the biggest one is Covid-19 stimulus. The U.S. government’s efforts to stimulate the economy have resulted in unprecedented monetary policy (i.e. low interest rates) and fiscal stimulus in the form of trillions of dollars of Covid relief.
“The conventional wisdom will tell you that when massive amounts of money are put into the system, all of that extra money effectively makes the money in circulation worth less than it was before,” says Chris Zaccarelli, chief investment officer for Independent Advisor Alliance in Charlotte, N.C.
The counterargument is that if stimulus efforts simply fill an economic hole, it doesn’t necessarily lead to excessive inflation.
“This is why inflation wasn’t an issue after the financial crisis, and why the debate is so interesting this time,” Zaccarelli adds. “People have already seen a situation where the Fed acted on a massive scale and we did not see inflation.”
Still, there are other signals that suggest inflation could make an appearance. The surge in popularity of SPACs and the rapid appreciation of speculative stocks, similar to what we saw in the late 1990s, are just some of the warning signs that the current monetary and fiscal stimulus in the economy may lead to inflation, Zaccarelli says.
Likewise, inflation expectations as measured by Treasury Inflation-Protected Securities (TIPS) have been increasing since last fall. Based on one-year TIPS, the market is pricing for 3.5% inflation over the next 12 months, says Graff, though this reflects an expected spike in spending related to wider distribution of Covid-19 vaccines.
A Fine Line Between Healthy and Worrisome
Investors should differentiate between worrying about inflation and worrying about significant inflation, notes Beata Kirr, co-head of investment strategies at Bernstein Private Wealth Management. She is not predicting inflation levels that are concerning.
Some inflation is indicative of healthy economic growth. Recently, the Federal Reserve said it will target an average inflation of 2% when looking at whether to raise, lower, or hold rates steady. The concern among some strategists is that by the time the Fed pumps the brakes inflation will already be a problem.
There are two main reasons why too much inflation can be worrisome. First, it creates a headwind for investors saving for the future or interested in preserving capital. “If inflation rises and yields don’t rise in a commensurate way, it’s essentially like losing money in real spending terms,” says Graff.
For many investors, the fear of inflation—and how markets will respond–is an even bigger threat. In general, the stock market does well when the economy has just the right amount of inflation, but only to a point.
“If inflation goes too high, that can cause a shock for the stock market,” Zaccarelli says, explaining that inflation itself isn’t the issue for markets, but rather the expectation of higher rates.
To complicate matters, measuring inflation isn’t a perfect science either. Strategists note that over the coming months it may be difficult to understand the true rate of inflation, for a couple of reasons. First, as we approach the one-year point for the economic trough of 2020, year-over-year inflation numbers could appear artificially high, says Michael Hans, chief investment officer at Clarfeld Citizens Private Wealth in Tarrytown, N.Y.
Secondly, assuming more vaccines translate to more economic activity, there is likely to be a surge in demand for goods and services hit hardest by the pandemic. “It’s very likely that inflation will appear to be very high in the back half of the year,” Graff says.
All Good Things In Moderation
There’s no silver bullet for protecting against inflation. And like everything, such measures are best in moderation. “Nothing is perfect, and everything will have a tradeoff,” says Kirr, explaining that she views any inflation-protecting assets, such as gold, inflation-linked bonds, or real assets broadly, effectively as insurance policies, for which investors are likely to pay a “premium” during non-inflationary periods.
“We think a diversified portfolio should incorporate some elements of inflation protection at all times because throughout this cycle, there could have been shocks that ultimately led to inflationary pressures,” Hans says. While every investor is different, well-rounded portfolios should include allocations to commodities, real estate, infrastructure, and other sectors of the economy that benefit from inflation.
On the fixed-income side, bond markets are constantly pricing for inflation. However, when there is a risk that inflation may suddenly spike, longer-duration bonds tend to see the most volatility. “We’ve been thoughtfully underweight duration,” Hans adds.
Meanwhile, many investors already own more than their share of inflation-friendly assets, including art, real estate, farmland, and other valuables that often stand the test of time. “While idiosyncratic, these can be very powerful inflation hedges already on their books,” Kirr says.