Portfolio steps to consider in an inflationary environment

Financial page of newspaper titled Interest Rates

Inflation has been on the rise, which may be problematic if your investments provide you with income. Learn about ways to manage your inflation exposure.

Brian Rehling, Head of Global Fixed Income Strategy, Wells Fargo Investment Institute
Brian Rehling,
Head of Global Fixed Income Strategy,
Wells Fargo Investment Institute

Anyone who has gone grocery shopping or filled their car’s tank up with gas in the last few months couldn’t have failed to notice that prices have risen. What’s more, these price increases are not confined to just the basic necessities. For example, if you are in the process of remodeling your house you also may be feeling the inflation pinch as materials shortages may have boosted construction costs.

Rising prices–a fixed income investor’s enemy

We project that the rate of inflation will average 3.8% this year, well above the average of 1.7% we’ve been used to over the past 10 years.  After an extended period of stable prices such price increases may come as a shock to those who rely on bonds and other fixed income investments for capital preservation, cash flow or liquidity.

Rising prices can eat into what you’re able to buy with the fixed schedule of cash flows your bond portfolio can potentially provide. Over time it can lower the purchasing power of your investment portfolio as a whole.

What steps can you take to help your portfolio in an inflationary environment?

There are steps you can consider that may help your portfolio in an inflationary environment. It is worth noting that each comes with caveats that you should carefully consider before investing:

  • Treasury Inflation-Protected Securities (TIPS) may be high on your fixed income shopping list as you look to counteract the impact of inflation on your portfolio. TIPS can offer some purchasing power risk mitigation for a Treasury bond portfolio. Consider a new-issue TIPS and holding to maturity for the assurance that your investment will be indexed to the Consumer Price Index. On the downside, the current negative real yield environment implies a small negative return over the life of a new TIPS security when adjusted for inflation. Moreover, if you purchase TIPS in a taxable account there may be additional tax consequences.
  • Equities potentially can be a good choice during times of high growth and higher than normal inflation. But it is worth remembering that performance can be more volatile than many fixed income investments without the built in income stream.

At this point in the economic cycle we anticipate small-cap and emerging-markets asset classes may perform well. Both are very sensitive to improving economic growth, and have done well historically when things were heating up (usually also when inflation made an appearance).

Cyclical sectors that have tended to outperform include materials, energy, industrials, and financials. The first three are most directly exposed to stronger economic growth. For example, we would expect the manufacturing sector to perform well early in an economic cycle if new orders pick up and inventories are rebuilt as we anticipate.

Financials historically have been a tangential beneficiary as a strong economy has helped to improve credit quality (better income prospects), asset values (higher prices) and has often delivered a steeper yield curve which helped drive earnings.

  • Commodities have generally been one of the long-standing inflation hedges to which investors often turn; however, it is worth noting that each inflation cycle is different. This cycle is being driven by strong economic growth, potentially benefiting oil over gold—the more traditional inflation hedge option.

In this cycle the gold price has to contend with real interest rates hovering near all-time lows. If real rates do not fall further over the coming years, we believe gold prices may pause, which could negate their ability to rise faster than the rate of inflation.

Alternative Investments may offer another option for qualified investors. A Private Debt Direct Lending strategy can potentially be both a yield enhancer and inflation hedge. Direct lending to non-investment grade businesses rebounded from the depth of the pandemic and generated strong performance in 2020, strengthening our conviction in its resilience. At the same time, traditional bank lenders are less able to provide long-term financing to these businesses that will likely continue to need financing for growth and development if the economic recovery gains momentum in a post-pandemic world.

Remember what I said earlier about all the caveats associated with investing in an inflationary environment? There is, of course, a downside to this strategy: You have to be willing and able to sacrifice liquidity and take on some additional investment risk.

I recommend you discuss any of these strategies with an investment professional before investing, specifically: The tax and investment implications associated with TIPS; your risk tolerance for Equities and commodities; and the implications of giving up liquidity associated with alternative investments.

On a more reassuring note, while a rising rate of inflation may be a bit unnerving in the short term, we do not anticipate a return to the runaway inflation of the 1970s and early 1980s. With this in mind, think about your investment objectives before making any significant adjustments to your portfolio.

 

Wells Fargo Investment Institute, Inc. is a registered investment adviser and wholly-owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

Different investments offer different levels of potential return and market risk. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Small- and mid-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. Treasury Inflation-Protected Securities (TIPS) are subject to interest rate risk, especially when real interest rates rise. This may cause the underlying value of the bond to fluctuate more than other fixed income securities. TIPS have special tax consequences, generating phantom income on the “inflation compensation” component of the principal. A holder of TIPS may be required to report this income annually although no income related to “inflation compensation” is received until maturity. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility.

Alternative investments, such as hedge funds and private capital/private debt strategies, are not suitable for all investors. Any offer to purchase or sell a specific alternative investment product will be made by the product's official offering documents. Investors could lose all or a substantial amount investing in these products. Some alternative strategies may expose investors to risks such as short selling, leverage risk, counterparty risk, liquidity risk and commodity price volatility risk. In addition, alternative strategies engage in derivative transactions. Short selling involves the risk of potentially unlimited increase in the market value of the security sold short, which could result in potentially unlimited loss for the fund. In addition, taking short positions in securities is a form of leverage which may cause a portfolio to be more volatile. Derivatives generally have implied leverage and may entail other risks such as liquidity and interest rate and credit risks. Successful hedging strategies may require the anticipation of future movements in securities prices, interest rates and other economic factors. No assurance can be given that such judgments will be correct.