What portfolio management in case of inflation?

Is the recent rise in prices temporary or will it take hold?

In America as well as in Europe, everyone has noticed the rise in prices in recent months, particularly for energy or construction materials. These price increases (inflation) represent an increase in the overall average price level of an economy. The U.S. inflation rate recently reached 5% – the highest in the last 12 years – indicating that prices are generally rising and the purchasing power of the U.S. dollar is declining. The same phenomenon can be seen in Europe, with very large disparities between countries that have experienced measured or more extreme increases in certain price segments. Inflationary regimes are defined as those where inflation accelerates and reaches 5% or more per year. The developed world has not experienced such a situation for decades. Experience and limited recent data therefore make it difficult to design a portfolio for high inflation risk.

Policymakers often distinguish between temporary and longer-term inflation shocks. For example, the Fed and ECB consider pandemic-induced inflation to be merely temporary. However, monetary authorities have not always been trustworthy and large price “shocks” do not tend to occur, or resolve, overnight. There are risk factors that indicate that this inflation may be long term and the current surge may not be resolved as quickly as monetary authorities would like.

Serious inflation risks for 2021 and 2022

The most important investment question this year is whether the current runaway inflation is temporary, as central banks argue, or whether it marks a historic turning point.

According to the study published this summer in the “Journal of Portfolio Management” (see source) three factors suggest a higher risk of inflation in 2021:

The massive increase in money creation. The U.S. money supply (M2) increased from $15.5 trillion to $19.7 trillion between February 2020 and February 2021. Most central banks in the developed world have also contributed to the massive increase in money in circulation.
Extraordinary post-pandemic expansive fiscal policy: In relation to the huge political spending caused by the pandemic today, there have been only two other instances of consecutive double-digit deficit years in recent U.S. history (World War I and World War II).
The bond market is signaling increased inflation as long-term yields have recently risen.

These risks are largely a result of political and semi-state responses to the pandemic and long-term inflation now appears more likely.

Asset class responses to inflation in recent history

The core of the interesting study published this summer in the Journal of Portfolio Management analyzed the best performing investments in different markets and asset classes.

While it is impossible to predict inflation accurately, a review of the best-performing investment data during past inflation periods provides good guidance for positioning a portfolio during high inflation:

Commodities have positive returns during inflationary spikes, but this depends a lot on the types of commodities. It is such a diverse asset class that some move closely with inflation, others less so. The problem with commodities is that unless you are a professional in the industry, you can mainly gain exposure through derivatives contracts (mainly futures), whose long-term returns often depend more on the difference between the various futures prices than on the underlying commodity.
Stocks can provide some protection against inflation from a financing perspective (because the company’s debt obligations are reduced in real terms) and from an income perspective (product prices can be adjusted for inflation). In the case of extreme inflation, stocks suffer from a less stable economic climate, coupled with future economic weakness. Very high inflation is therefore generally considered a negative for equities, as it increases the borrowing and production costs (materials, labor) of companies, resulting in lower expected earnings growth. This economic uncertainty affects the ability of companies to plan, invest and develop longer-term partnerships. As a result, costs tend to rise with inflation more than selling prices. Furthermore, no equity sector offers significant protection against high and rising inflation; even the energy sector is barely positive in real terms in the event of very high inflation historically, despite US energy equities having almost doubled over the last 12 months.
Finally, sovereign inflation-protected securities (TIPS) are robust when inflation rises, giving them the advantage of generating similar real returns in inflationary and non-inflationary regimes, with both being positive. The principal of TIPS appreciates when inflation rises – but declines in deflationary environments, as measured by the Consumer Price Index. During periods of inflation, TIPS can provide additional returns and protection to a portfolio if traditional stock and bond prices decline in real terms. TIPS are available in terms of 5 to 30 years.

Which asset classes for private investors in times of inflation?

The best way to protect yourself against inflation, which is certain to occur in some form, is to invest your money – and the sooner the better. If you agree with the hypothesis that sustainable inflation is more likely than not, it is important to act, because ordinary bonds are very poor investments in the event of high inflation, while stocks as a whole have been rather poor.

Should you invest in commodities today against inflation?

In times of extreme inflation, distortions appear for all market participants. The study confirmed the common knowledge that the best historical performance is observed for commodities. However, this would be a speculative investment before widespread and persistent inflation occurs and commodities do not pay dividends. As such, you should generally avoid them unless you have very specific knowledge or are a professional in a particular commodity sector. As recommended by Boglehead Rick Ferri, avoid commodities as they are very speculative and do not pay you any income.

Is gold a good hedge against inflation?

Gold has historically performed well in high inflation, holding its value even in countries where inflation has risen to double digits. Thousands of years of history give it a strong case (if you get a chance, read Peter Bernstein’s excellent book – The Power of Gold: The History of an Obsession), but it’s possible that the bitcoin rush is partially disrupting its stabilizing power, with gold’s high price and lack of yield not making it a wise candidate for investors.

Should you take on debt in times of inflation?

Like commodities, real estate has always been considered a hedge against inflation. It is a tangible asset that tends to hold its value when inflation is prevalent. Rising prices lead to higher property values and rents, which increases the amount of rental income and the book value of the property. On the other hand, if the market correctly anticipates inflation or if other factors are driving prices up, as is the case in many cities in Europe and the United States, there is no extra money to be made by betting on this inflation and speculating in real estate, especially at the current high price level. In contrast to a bond strategy, one option is to take the other side of the equation and become a borrower instead of a lender: By taking out a 30-year fixed rate mortgage, you will also have a free refinancing option if inflation never arrives and yields fall. If inflation comes in full force, your debt will be reduced in real terms. Be careful with debt: You can only justify its use with a reasonable and solid real estate project.

What is the best equity strategy in the event of inflation?

If a company’s earnings are expected to decline in a high-inflation area, you can invest outside of that area in order to hedge an exposed portfolio (e.g. US) and capture potential returns from global markets where inflation may not be as high in order to reap the benefits of global market diversification.
Shares of miners, oil drillers and other commodity producers have not done as well as commodity prices during periods of inflation in the past, but have still outperformed the rest of the equity market. Copper and oil are up more than 30% this year and timber has nearly doubled, while global mining and major oil stocks have strongly beaten the broader indices. These companies have already seen their prices rise in anticipation of their earnings and specific investment vehicles are often more expensive. Even ETFs with attractive fees have seen their value rise sharply (+103.4% for the Vanguard Energy ETF with an attractive expense ratio of 0.1%). So it does not seem worthwhile to invest in them specifically at this point in time, as the sharp rise in energy prices has already been priced into the companies. You would probably already be too late to the party.
Growth stocks (growth, big tech) promise higher profits in the distant future and therefore seem less attractive in an inflationary environment. This is an argument for investing in value stocks that are not as highly priced as growth stocks. In addition. when prices rise across the board, weaker and less popular companies may also price more aggressively, and pricing power becomes less important. According to Ben Funnell (Man Group), the stocks of these weaker companies outperformed during the first three quarters of every inflationary episode in the U.S., and then largely underperformed during the end of inflation. Thus, while value and weaker companies have the potential to protect against inflation, they require active monitoring.

Are bonds and TIPS an option against inflation ?

Assets with long maturities will be affected by growing fears of an inflationary spiral, and those with fixed yields – bonds – will be the most likely to be affected by inflation. Avoid them as much as your situation allows ! The idea is to favor assets with short durations. One solution would be TIPS, but their yield is very low and the current low probability of very high inflation makes this type of investment unattractive, at least in the coming months and at this price level. In addition, they are very expensive, with 10-year TIPS paying 0.9% less than inflation. A limited alternative: U.S. individual investors can and should have the maximum of $10,000 per year in Series I Treasury Savings Bonds, whose interest rate adjusts for inflation, but never falls below 0%.

Final tips for post-pandemic portfolio management

As you continue to invest during inflation, you must ensure that you preserve the purchasing power of your portfolio and continue to grow your nest egg. You should continue to follow the principles of diversification: Spreading risk over a variety of securities through ETFs is a traditional method of portfolio construction that applies to both inflation and asset growth strategies. This way, you won’t be distracted from your long-term goals by making minor adjustments to certain categories.

Historically, since trend following offers the most reliable protection during major inflationary shocks, you should not get ahead of yourself by investing heavily in speculative non-dividend commodities or low-yielding TIPS, since it is not yet certain that such inflation will take hold in a strong and sustained manner. A trade-off between your strategy and what inflation would require is inevitable, as there is no perfect portfolio that works perfecly if inflation appears and avoids the breakage if it does not. Don’t revolutionize your portfolio despite these new risks.

While stocks suffer in the event of extreme inflation, they still offer acceptable protection in the event of limited inflation. Since no sector offers a perfect hedge, you should not need to invest in a specific sector ETF with additional costs. In case of high inflation, rising interest rates would lead to a higher cost of capital in valuations and would reduce all stock prices without exception: Diversified ETFs therefore remain the preferred choice for value-oriented private investors (see practical options here).

In summary, it is not a matter of changing your course despite these risks that are materializing, but of monitoring the situation and making some adjustments such as limiting stock growths (whose prices are at extreme levels) and moving to more value: For example, Vanguard’s VT value (VTV) has a P/E of 17.5, a P/B of 2.7 for an expense ratio of 0.04 but it only invests in US companies. The international version is too expensive at 0.35% for Vanguard and 0.30% for its iShares equivalent. A global ETF allows for international exposure and good diversification of your portfolio, whether you are European or American, but most are distorted by the high prices of growth stocks.

Thus, inflation risks should never rule your portfolio management. If you have specific goals or timetables for your investment plan, do not deviate from them. So don’t overload your portfolio with TIPS. Don’t buy long-term growth stocks and favor value-diversified stocks (e.g. with VTV in case your exposure to the US market is insufficient, which is a rare case). An obsession with inflation should never take you out of your risk tolerance zone or lead you into dangerous territory like commodities. Continue your international diversification, with a small value bias if your situation allows it (stay the course).

Source : The Best Strategies for Inflationary Times, The Journal of Portfolio Management, August 2021, 47 (8) 8-37, Henry Neuville, Teun Draaisma, Ben Funnell, Campbell Harvey et Otto van Hemert