Protecting Your Portfolio from Inflation
The 2016 election revived the hopes of some market participants for higher interest rates and higher inflation. Indeed, the 10-year Treasury rate went from 1.45% in July to 2.5% in December before settling at around 2.35-2.40% at the end of February 2017. Simultaneously, the Consumer Price Index, which is one of the leading inflation indicators, hit a five-year high level at 2.5% in January 2017. As many investors are becoming more concerned, we will discuss our top 5 strategies to protect your portfolio from inflation.
Higher interest and inflation rates can hurt the ability of fixed-income investors to finance their retirement. Bonds and other fixed-income instruments lose value when interest rates go up and gain value when interest rates come down.
There were numerous articles in popular media about the “great rotation” and how investors will switch from fixed to equity investments in the search for a higher return. None of that has happened yet, and the related news has seemed to disappear.
However, the prospects for higher inflation are still present. So, in this article, I would like to discuss several asset classes that are popular among individual investors. I will explain see how they perform in the environment of rising inflation.
Cash is by far one of the worst vehicles to offer protection against inflation. Money automatically loses purchasing power with the rise of inflation. Roughly speaking, if this year’s inflation is 3%, $100 worth of goods and services will be worth $103 in a year from now. Therefore, someone who kept cash in the checking account or at home will need extra $3 to buy the same goods and services he could buy for $100 a year ago.
A better way to protect from inflation, while not ideal, is using saving accounts and CDs. Some online banks and credit unions offer rates above 1%. This rate is still less than the CPI but at least preserves some of the purchasing power.
Stocks are often considered protection tools against inflation. They offer a tangible claim over company’s assets, which will rise in value with inflation. However, historical data has shown that equities perform better only when inflation rates are around 2-3%. To understand this relationship, we have to look at both Real and Nominal Inflation-Adjusted Returns. As you can see from the chart below, both real and nominal stock returns have suffered during periods of inflation that is over 5% annually. Moreover, stocks performed very well in real and nominal terms when inflation rates were between 0% and 3%.
High inflation deteriorates firms’ earnings by increasing the cost of goods and services, labor and overhead expenses. Elevated levels of inflation have the function to suppress demand as consumers are adjusting to the new price levels.
While it might look tempting to think that certain sectors can cope with inflation better than others, the success rate will come down to the individual companies’ business model. As such, firms with strong price power and inelastic product demand can pass the higher cost to their customers. Additionally, companies with strong balance sheets, low debt, high-profit margins, and steady cash flows tend to perform better in a high inflation environment.
Real Estate very often comes up as a popular inflation protection vehicle. However, historical data and research performed the Nobel laureate Robert Shiller show otherwise.
According to Shiller “Housing traditionally is not viewed as a great investment. It takes maintenance, it depreciates, it goes out of style. All of those are problems. And there’s technical progress in housing. So, the new ones are better….So, why was it considered an investment? That was a fad. That was an idea that took hold in the early 2000s. And I don’t expect it to come back. Not with the same force. So people might just decide, ‘yeah, I’ll diversify my portfolio. I’ll live in a rental.’ That is a very sensible thing for many people to do”.
Shiller continues “…From 1890 to 1990 the appreciation in US housing was just about zero. That amazes people, but it shouldn’t be so amazing because the cost of construction and labor has been going down.” Rising inflation will lead to higher overhead and maintenance costs, potential renter delinquency, and high vacancy rates.
To continue Shiller’s argument, investors seeking an inflation protection with Real Estate must consider their liquidity needs. Real Estate is not a liquid asset class. It takes a longer time to sell it. “Every transaction involves paying fees to banks, lawyers, and real estate agents. There are also maintenance costs and property taxes. The price of a single house also can be quite volatile.” Just ask the people who bought their homes in 2007, just before the housing bubble.
Commodities and particularly gold tend to provide some short-term protection against inflation. However, this is a very volatile asset class. Gold’s volatility measured by its 42-year standard deviation is 33% higher than that of stocks and 3.5 times greater than the volatility of the 10-year treasury. Short-term inflation protection benefits are often overshadowed by other market-related events and speculative trading.
Not to mention the fact that gold and other commodities are not easily available to retail investors outside the form of ETFs, ETNs, and futures. Buying actual commodities can incur significant transaction and storage cost which makes it almost prohibitive for individuals to physically own them.
According to many industry “experts” bonds are a terrible tool to protect for inflation. The last several years after the great recession were very good to bonds since rates gradually went down and the 10-year treasury rate reached 1.47% in July 2017. The low rates were supported by quantitative easing at home and abroad and higher demand from foreign entities due to near zero or negative rates in several developed economies. As the rates went up in the second half of 2016, bonds, bonds ETFs and mutual funds lost value. While bonds may have some short-term volatility with rising inflation, they have shown a strong long-term resilience. The 42-year annualized return of the 10-year Treasury is 7.21% versus 10.11% for large Cap Stocks. The Inflation adjusted rate of return narrows the gap between two asset groups, 3.07% for bonds and 5.85% for stocks.
For bond investors seeking inflation protection, there are several tools available in the arsenal. As seen in the first chart, corporate bonds due to their stronger correlation to the equities market have reported much higher real returns compared to treasuries. Moving to short-term duration bonds, inflation-protected bonds (TIPS), floating-rate bonds, are banks loan are some of the other sub-classes to consider