Portfolio Allocation in Times of Inflation

Inflation is rising. It would in our opinion be wise to prepare for it.

Don’t get us wrong. We aren’t returning to the white-hot inflation rate of 1980, which reached 14.8 percent. But there is enough evidence to believe that a further upturn in inflation is coming. The question is how much inflation and for how long. The Federal Reserve takes a sanguine view, saying it expects inflation to average 2.4 percent this year and decline to 2.1 percent by 2023. Inflation at that level would be no big deal. Long-term investors with well-diversified portfolios of stocks and bonds could pretty much ignore it.

But we at Calvin • Farel believes that the inflation rate could exceed 4 percent and even reach up to 7 percent over the next few years. Our unscientific view is that the risk of that happening is less than 50-50 but still high enough to readjust some investment assumptions.

For one thing, if inflation does climb, the Fed (Federal Reserve) would need to tighten financial conditions by reducing its bond purchases and by raising short-term interest rates. The markets would almost certainly become more volatile. Bonds would decline in value, because bond yields and prices move in opposite directions. The stock market would initially be unsettled. It needn’t all be bad news, though, once the shock ebbs.

In inflationary environments, stocks often prosper, particularly those that pay high dividends. Home prices and commodities like gold, silver, copper and most probably bitcoin often rise, too. Treasury Inflation Protected Securities (TIPS), and Treasury inflation-indexed I-bonds, both introduced in the late 1990s, could hedge against rising prices. And bond portfolios would eventually generate better returns as investors shifted to higher-yielding securities. That all comes from the standard playbook for investing in an inflationary period, and you may want to become familiar with it, incase you need to use it. We are expecting the yield on the 10-year Treasury note likely to reach at least 2.25 percent this year, up from roughly 1.6 percent. Now you probably wouldn’t want to hold long-term bonds if inflation spiked further, because they decline in value most sharply as interest rates rise

Shorter-duration bonds – and bond mutual funds and exchange traded funds (ETFs) – would incur losses briefly, but long-term, buy-and-hold investors in our opinion needn’t worry much about it. That’s because the total return for bonds, and for bond funds, comes from both price and yield. Yields in the bond market would be moving higher, even as their prices fall, and savvy investors could trade low-yielding bonds for securities with richer income streams, which would in our opinion eventually produce greater returns.

That shift would occur beneath the head of bond portfolios, in diversified index funds and well-managed active funds. Most important, high-quality bonds – held individually or in funds – would in our opinion probably buffer a stock portfolio in a sharp downturn, as they did when stocks crashed in February and March 2020. In short, many bond portfolios would generate small losses initially as inflation and interest rates rise, but in our opinion, they would recover and would still be worth holding.

As for stocks, the market is likely to be rocky if the Fed needs to respond to inflation – witness the 2013 “taper tantrum”, in which the Fed discussed reducing bond holdings and stocks briefly fell. After the early turmoil, stocks in our opinion should prosper – mainly dividend-paying value stocks, rather than tech growth stocks – as they have in past inflationary surges, as heightened inflation at that point of time is already “baked in”.

We at Calvin • Feral are expecting up to 20 percent inflation, cumulatively, over the next three years. The United States money supply has grown 30 percent since the Fed and the government intervened in the economy in March 2020. With such an increase, we are going to have a burst of inflation. There could be a year of up to 7 percent inflation, one with 5 percent. While the Fed will need to respond under such a scenario, it’s not likely to be facing a runaway wage-price spiral, requiring the harsh medicine of a recession, the cure imposed by Paul A. Volcker after he became Fed chairman in 1973.

A modest uptick in inflation – below 3 percent – would scarcely be noticeable. But sharp increase over a sustained period, like those of the 1970s and early 1980s, would be another matter. Back then, prices of real assets like houses, gold and oil soared. Average mortgage rates exceeded 17 percent, and interest on bank certificates of deposits approached 12 percent. It was hard to know whether a 5 percent pay raise was cause for celebration or despair.

The current inflation surge has been much milder, so far, and, because of the pandemic, it may be fundamentally different. A combination of supply shortages, extra savings and pent-up demand account for many of the price increases showing up in the official government figures. But the extent of those increases has been worse than many economists expected. The Consumer Price Index in April rose 4.2 percent over the previous year, the biggest increase since 2008. The Feds preferred index – the Bureau of Economic Analysis’ personal consumption expenditure inflation measure – rose 3.6 percent in April from the prior year, the biggest gain in 13 years stripping away food and energy prices, that core price index rose 3.1 percent, the steepest increase since 1992.

The Fed and the government of the US have in our opinion injected so much money into the economy (with more likely to come) that the risk of a further, sustained inflation increase can’t be entirely discounted. We are projecting that there is roughly a 40 percent chance that inflation will be above 4 percent next year and the year after if the Fed does not tighten monetary policy. But there is considerable uncertainty to any prediction in the current environment. We certainly can’t predict the inflation rate. Yet we do remember the 1970s, when it was sensible to think that a dollar would be worth only 80 cents in three years – unless it was invested in stock or real estate or gold. That is emphatically not where we are now, but for the first time in years, it seems sensible to get (back) into the habit of thinking about inflation.