By Daniel Plaut, CFA®
If you have turned on CNBC, read the Wall Street Journal, or consumed any financial news as of late, you have no doubt heard about inflation. Inflation is a general rise in the level of prices and is measured by the Consumer Price Index or CPI.
The U.S. Labor Department reported recently that the CPI rose 4.2% year-over-year in April, the fastest it has grown since 2008. Economists were expecting a 3.6% increase. This higher-than-expected inflation is negatively affecting both stock and bond markets.
There are a few big factors driving above-average inflation:
Individuals receiving and spending their stimulus checks.
Because unemployment benefits have been so high, employers are offering higher wages to get people to come back to work. For example, Chipotle recently announced it will raise wages across the board, to an average of $15 an hour, as it struggles to fill job openings.
Expectations of increased government spending resulting from Biden’s proposed infrastructure and family plans.
Inflation reduces purchasing power and causes the fixed future cash flows of bonds to have less value. As a result, investors sell bonds since the net present value is now lower than expected when the bonds were purchased. The longer the maturity of the bond, the more pronounced the effect of inflation on its value. The 10-year Treasury yield increased over 3.5% on May 20 as a result.
For stocks, the effects of inflation are less clear-cut. In the short term, inflation increases the cost of inputs (like how rising wages increase the cost of labor), eating into corporate profits and decreasing stock prices (Chipotle stock fell over 3% after its announcement). In the long term, companies raise prices and ultimately shift the rising costs to the consumer.
This means stocks can actually be a good hedge against inflation, given a long enough time horizon. This is truer for larger companies than smaller ones. Additionally, growth stocks tend to underperform value stocks in periods of high inflation. Growth stocks derive their value from expectations of higher future revenue and cash flows. Increasing inflation decreases the present value of these future cash flows.
The bigger issue for the stock market is that increasing inflation leads investors to believe that the Fed may need to raise interest rates sooner than expected. This is especially relevant in the current environment because interest rates are so low right now, meaning the cost of borrowing money is cheap, which in turn leads to economic expansion. When the Fed raises interest rates it effectively makes money more expensive and slows down economic expansion.
So, what can you do about it in your portfolio? Again, stocks can perform well with inflation over the long term, so an equity-heavy portfolio with a long horizon likely offers nothing to worry about. But for portfolios with more fixed income, or with shorter horizons, it is a good idea to consider other investments that hedge against rising inflation.
Treasury Inflation-Protected Securities (TIPS) are government-issued bonds that rise in value along with rises in the CPI, thus providing good protection against inflation. That being said, they generally have lower returns than many other assets.
High-yield bonds tend to outperform other bonds in high inflation. The higher yields become more attractive as inflation rises, and because their higher payments are worth less than expected at the time the bonds were issued, it is less likely that companies will default on payments.
In terms of non-fixed-income assets, real estate and commodities tend to perform well when there is high inflation. With real estate, rent can be increased along with inflation. For commodities, inflation means a general rise in prices, including for those items that are bought and sold. Real estate investment trusts, or REITs, can be used to gain exposure to real estate, and there are various types of commodity funds that can be used to invest in commodities.
All that being said, while inflation is currently all over the news and is a justifiable concern for retirees with a fixed income, there’s no guarantee that significantly higher inflation will happen for an extended period of time. At Williams Asset Management, we are monitoring and researching the situation and will update our portfolio allocation models as needed.
Daniel Plaut is a chartered financial analyst with Williams Asset Management in Columbia.