Explaining Effects of Inflation on Your Portfolio and What to do About It!
By Derek Moore
Stock and Bond Returns During Different Inflation Environments
Despite what many may think, stocks have experienced positive nominal returns even during periods of severe inflation in the United States.
Even after accounting for inflation, only in the severe periods do stocks have a negative real return (after inflation) while bonds suffer negative real returns even in periods of just high inflation.
O’Shaughnessy Asset Management back in 2011 published a piece showing how stock and bonds did across various types of inflationary regimes
Inflation Effect on Portfolios
Inflation and responses to it have the potential to add more volatility to the stock market.
In the bond market due to the inverse relationship between interest rates and bond prices, we may see even more outside realized volatility compared to historical averages. Beyond volatility, when inflation is higher, investors require more return to outpace the negative impacts of price increases.
Traditional approaches, especially fixed income, may see additional negative pressure given unlike the late seventies where yields were significantly higher, bond yields are still on the low end for generations of bond investors.
This means that with a lower starting point in yields, coupon payments may not be high enough to supplant market price declines should interest rates rise materially in response to inflation.
Inflation’s Effect on Certain Sectors
As Jay Pestrichelli pointed out to Reuters, some areas may be more susceptible to higher rates than others:
"Watch for interest rates to apply some pressure to the tech stocks. So, if we do get higher rates - tech will slow down a little bit and a rotation to financials makes sense in that scenario. Higher rates, banks make more money," Jay Pestrichelli, CEO ZEGA Financial.
A natural place to look for inflation hedges would be commodities which have already run up a great deal.
But rather than trying to pick winners and losers, or time the market, there are other ways to hedge inflation risk in your portfolio.
Did You Know You Might Already Be Hedging Inflation?
That is if you are in ZEGA’s Buy and Hedge Retirement Strategy.
In a hedged portfolio that puts a floor beneath the market to look to remove material annual downturns, you own more of what historically has shown to have a better outcome in periods of severe and high inflation than bonds.
As an alternative to a 60/40 stock and bond portfolio, you’ve reduced exposure to negative effects on negative interest rate changes to intermediate to long-term bonds.
Take the 10-year treasury bond yielding around 1.6%. With inflation elevated, its real return after inflation is quite negative.
Instead, we utilize short duration bonds that have less interest rate risk as a funding source for our equity exposure that is hedged while containing also being hedged.
ZEGA’s Buy and Hedge Retirement provides an alternative to traditional stock and bond asset allocations with the opportunity to still participate in most of the upside with material hedges below.
How Real Is Inflation?
CPI Annual Increase 1948- 2021 (YTD Through October)
Data Source: Federal Reserve Bank of St. Louis with Authors Calculations
Last week October’s inflation data was released showing it continues to be neither temporary or transitory as the Federal Reserve or politicians have been explaining.
On the graph above the last bar on the right in orange shows through October, year to date all-items CPI is up 5.8% with two months still remaining. Also highlighted are years with at least 5.8% inflation. You must go back to 1990 to find the last time it has been this high. Before that the 1973 to 1981 era.
Given its continued run and how much even local media outlets are covering it, the public believes it is concerning as shown in the University of Michigan 1-year forward inflation expectations survey.
University of Michigan 1-Year Forward Inflation Expectations 1978 – October 2021
Source: Federal Reserve Bank of St. Louis
Contrarians might point to crowds being wrong in the long run while others point out that sometimes inflation (or deflation) feeds on itself causing more demand to be brought forward for fear of rising prices.
The measured view on this might point to an alternative view of the Sticky CPI vs the Flexible CPI. Flexible items are those more apt to move around in price while sticky items are much more stable.
Monthly Annualized Sticky CPI (Orange) vs Flexible CPI (Grey) 1967- October 2021
Source: Federal Reserve Bank of Atlanta
While the grey Flexible CPI has surged to levels not seen since 1980, the Sticky CPI in orange has barely budged. Compared to the 1970s to early 80’s period where they moved in higher correlation.
So, while inflation has been more than transitory, there is some nuanced views of the numbers with some unknowns.
But still, do you really want to be making portfolio decisions that hinge on whether inflation is transitory or not?
Use ZEGA’s Growth Simulator Yourself to Measure Inflations Effect on Your Wealth
If you haven’t already checked out our new tools, you can access by clicking here.
One of the inputs allows you to change your inflation forecast. See what happens to your required income after retirement and expenses. Think about how much growth you still might require in reaching your goals.
We plan additional features but feel free to drop us a line with feedback on our simulator.