Put simply, as the cost-of-living swells, a portfolio’s real returns decline. This is of particular concern to retirees living on a fixed income.
Rising prices also impact corporate profits, so in general, rapidly rising inflation and persistently elevated inflation levels are usually negative for stocks. For example, between 1973 and 1981, inflation rose by more than 9% a year. During the same period, the S&P 500 shed about 4% annually.
Through this period, the traditional 60/40 portfolio (60% stocks/40% bonds) was down 19.4% year-to-date through the end of August, on track for its worst year since 1936, its worst performance in decades. Thus, investors are increasingly considering different strategies and portfolio adjustments.
So what are your options?
Treasury Inflation-Protected Securities (TIPS): TIPS are designed to protect your investment from inflation. The U.S. Treasury sells TIPS and annually adjusts their par value to track inflation. This increases the interest payments investors enjoy and ensures your purchasing power isn’t eroded. However, these investments will not necessarily provide capital appreciation, and interest payments will decrease as inflation falls.
Value Stocks: Companies that appear to be trading at a low price relative to their fundamentals (dividends, earnings, sales, book value, etc.). These companies, often in industries such as the financial and consumer staples sectors, may be less affected by inflation and/or tend to have pricing power.
Dividend-Paying Stocks: Companies that can pay a hefty dividend, at or near the rate of inflation, help offset the erosion in buying power. There are lists of ‘dividend darlings’ or companies with very high dividend yield. However, on balance, many dividend-paying stocks can be sensitive to interest rate fluctuations and inflation, while some may be forced in time of economic stress to reduce or cut their dividends altogether.
Real Estate: Another tried-and-true inflation hedge is real estate given it’s necessity (which lends itself to the ability to rent it) and scarcity—as the saying goes, “they aren’t making any more of it.” Rates of rental growth generally increase over time as populations increase and supply of new property typically declines in times of high inflation. The scarcity itself helps to drive appreciation of land and developed real estate. Generally speaking, high rates of inflation increase building costs, which drive prices higher for new properties, thus pulling prices of existing properties higher. Lastly, real estate does not typically correlate too closely with bonds or stocks.
Hard Assets – Gold, Silver, Other Metals, Diamonds & Gemstones, Fine art, Collectibles: Gold is heralded as “the inflation hedge”, as it has intrinsic value (never goes to zero), does not corrode like Silver, has many industrial and commercial uses, and has served both as currency and as the underlying value against which currencies have been based for millennia. Silver, Platinum, Palladium and other metals can serve as an inflation hedge and investable asset given they too have industrial and commercial uses. Diamonds and gemstones tend to retain their value and can serve as a means of exchange when currencies or economies collapse and chaos ensues. Fine art and other collectibles (cars, jewelry, antiques, memorabilia, etc.) can be a store of value when inflation eats away at a currency.
Option-Based Strategies, like Hedged Equity: The universe of hedged equity strategies is pretty vast, but in general, hedged equity refers to investment strategies that invest in equity securities and seek to provide some hedge against losses. The objective for investors in time of high inflation, who cannot know when inflation will subside or when the equity markets will begin to price in a recovery, is to remain invested to seek whatever gains they can to offset erosion of purchasing power.
Persistently elevated rates of inflation can be troublesome for nearly any investment, but stocks have held their own versus other asset classes in such scenarios and can be one of the first to rise out of the ashes of an economic downturn.
A hedged equity strategy that provides exposure to a broad index, like the S&P 500, Russell 2000 or EAFE, can help mitigate single stock or sector risk. Then, based on how the hedging is executed, the hedged equity strategy may experience less volatility and overall drawdown risk than the underlying equity index, thereby benefiting the investor through the math behind investment returns.