Why rising inflation is a concern for investors
Inflation headlines are as common as red lights on roads lately. The word itself – “inflation” – seems to spark more fear than a potential market downturn, causing panic that financial factors could be outside of our control for the foreseeable future. However, a realistic look at where we are today compared to other points in history should dispel such fears and remind us that this is likely not the end of the world as we know it but rather a natural part of the cycle for which we prepare.
Investors of the late 1970s might be a bit more sensitive to current inflation news than others, but the stratospheric levels we saw extend into the early ‘80s are not where we expect to go. As the folks at Schwab point out, that time was a “unique event in modern history, driven by a change in the structure of exchange rates, demographics, oil price shocks, expansive fiscal policies, as well as monetary policy errors.” Those are different circumstances than we face today. That said, we are seeing factors that have kept inflation low ebbing, and the 2% to 3% inflation range represents a change from where it has been since the financial crisis of 2009.
When the global pandemic hit hard, companies cut production because demand plunged and was forecasted to remain low. The economic rebound post-vaccine distributions has been faster than expected – leading to production shortages and higher prices.
Inflation in simple terms is a sustained rise in overall prices levels – not simply the rise of prices. During economic growth, a degree of inflation should be expected because demand increases beyond the supply of goods, producers raise their prices and inflation increases. Inflation’s causes are still argued among economists, but it’s generally accepted that there are two types:
- Cost-Push: This is an increase in what we pay for basic goods like oil or lumber. Our ability to spend on shopping, entertainment and restaurants, which promises continuing economic growth, diminishes because we have less in our pockets after paying for life’s necessities.
- Demand-Pull: This happens when overall demand in our economy rises faster than goods can be delivered to shelves, cars to dealership, parts to manufacturers, etc. Combined with a rising money supply into economies (such as current pandemic relief programs) the inability to increase production of goods to meet demand drives prices up.
Both scenarios are based on demand outpacing supply in the economy or “too much money chasing too few goods.” When the demand for goods and services is greater than the economy’s capacity to provide them, prices will rise, and there is less in our pockets.
Inflation proofing with resilient sector selection
Owning stocks that pay a growing stream of dividends is a great way to preserve spending power. With inflation’s negative impact on spending, strong dividend-growing companies and high-yielding dividend companies provide a way for investors to keep up with rising prices – unlike bonds, whose fixed interest payments and principal are eroded by inflation.
History shows that certain sectors can providing rising streams of dividend income in times of rising prices and increasing demand. According to data from Evercore strategists, the financial sector sees the highest degree of outperformance against the S&P 500 when long-term yields rise. The energy sector is the second-best performer and industrials are third. The sectors least correlated with higher interest rates are defensive ones or those whose revenues and earnings are less influenced by economic demand.
For banks, loans are more profitable when long-term rates are higher. Power companies meet this risk by selling electricity under long-term contracts that include annual escalators linked to inflation. Also, utilities can seek increased rates to charge customers. Prices rising on beef or coffee impact fast food restaurants (such as McDonalds or Starbucks – both rising dividend annual increasers) and mean customers might be charged more. Passing-through higher costs is perhaps not ideal but very manageable. Fast food and service restaurants that offer cheaper goods have potential for more market share in tough times because with less money in our pockets, it’s burgers and hot-dogs over steaks and shrimp scampi.
Other financial strategies to protect against inflation
Not all bonds are to be avoided during inflationary periods. In 1997, the U.S. introduced Treasury Inflation-Protected Securities (TIPS), which have a fixed coupon, but their principal value (or “maturity amount”) is periodically adjusted based on the rate of inflation. The fixed coupon rate does not change, but the coupon payment increases with an increase in principal value. This provides an income stream linked directly to inflation – allowing for the bond to potentially be worth more at maturity than the original principal paid.
Funds invested in inflation-protected bonds, whose face value rises with the consumer-price index, have seen strong inflows since last May, according to a recent Deutsche Bank report. The amount invested in those funds in the past year was the highest since 2010.
Floating rate notes add portfolio pricing stability during rising inflation. These offer coupons that adjust up and down with key interest rates, which are reset periodically to reflect changes in the index to which it is tied.
Duration is the expected volatility in a bond price relative to percentage increases/decreases in interest rates, and it’s important to keep low duration risk to cushion against rising inflation’s detrimental effects. Simultaneously, investors can take advantage of periods of rising yields to add medium- to long-term bonds in upcoming years to produce more portfolio income. Individual bond durations can then become a function of a portfolio’s average duration. This can allow for opportunities to add higher rates of return on longer maturities as rates climb.
Implementing strategies like bond ladders or barbells, which divides the allocation between short- or intermediate-term and long-term bonds, can help “average in” to higher yields over time. Bond ladders are very useful because they help balance the desire for income today with the desire to “time the market.”
Reassurance for the worried investor
First, don’t panic. Although it’s true that the stock market went sideways during the 1970s and early ‘80s when U.S. inflation hit a high of nearly 15 percent and unemployment reached nearly 10 percent, few economists or policy makers are expecting a repeat of such extremes.
The Fed’s target to keep rates low coupled with the trillions in government relief has delivered stronger demand, which could provide the foundation for inflation to be higher than we’ve seen in the past decade. However, there are other opinions that the post-pandemic economic recovery will produce a boom year in 2021 but not spur swiftly rising and sustained interest rates and inflation.
The bottom line is no one has a crystal ball to predict the duration or impact of inflation. It’s important to be mindful of the factors at play, but there’s plenty you can do to minimize its impact. Maintain good allocations and investment mixes. When prices rise, revisit your budget and adjust your lifestyle so spending doesn’t follow suit. Understand your Social Security options and use a strategy for claiming benefits to maximize the income possible. Stay in contact with your financial advisor, and make sure you feel informed about the path to financial security.
Wayne Anderman CFP® MBA is the founder of Anderman Wealth Partners, based in the Greater Fort Lauderdale Area, and a registered representative of Avantax Investment ServicesSM. Member FINRA, SIPC. Investment advisory services offered through Avantax Advisory Services.
Sources:
https://www.schwab.com/resource-center/insights/content/inflation-expectations-are-up-should-investors-worry
https://europe.pimco.com/en-eu/resources/education/understanding-inflation
https://www.theglobeandmail.com/investing/education/article-how-dividend-stocks-can-protect-you-from-inflation/
5 High-Yield Dividend Stocks to Protect Your Retirement From Inflation | The Motley Fool | These 3 Stocks Turn Inflation Into Surging Dividends (forbes.com)
https://www.barrons.com/articles/if-inflation-is-coming-these-stocks-will-benefit-the-most-51613997007?mod=article_inline
https://www.clevelandfed.org/newsroom-and-events/publications/economic-trends/2014-economic-trends/et-20140417-pce-and-cpi-inflation-whats-the-difference.aspx
https://www.forbes.com/sites/brettowens/2021/04/21/these-3-stocks-turn-inflation-into-surging-dividends/?sh=3d209d7fd11e
This information is intended to be for illustrative purposes only and does not reflect any particular investment or investment needs of any specific investor. By including these links, we are not making a specific product recommendation.
Diversification and asset allocation do not assure or guarantee better performance/profit and cannot eliminate the risk of investment losses in declining markets. Investments are subject to market risks including the potential loss of principal invested.
These opinions are based on observations and research and are not intended to predict or depict performance of any investment. These views are as of the close of business on 06/07/2021 and are subject to change based on subsequent developments. Information is based on sources believe to be reliable; however, their accuracy or completeness cannot be guaranteed. These views should not be construed as a recommendation to buy or sell any securities. Past performance does not guarantee future results.
