Telemus Special Market Commentary: Investing in Times of Inflation

In our previous article, we looked at the current inflationary environment. As part of our discussion we noted the range of inflationary outcomes remains considerably wide. Given this, we don’t believe it is prudent to invest for a specific inflation expectation. Rather, investors should understand their sensitivity to inflation and be aware of the array of potential solutions to help weather an episode. In this piece, we look at how to think about this in the context of your financial planning needs as well as portfolio composition.

Impact of inflation on your portfolio

The first question investors must answer is what risks they face with heightened inflation. To some degree, an individual’s vulnerability to inflation is going to be unique to their own circumstances. For those who spend a meaningful portion of their income on a mortgage payment, that element of their spending is fixed and will not be impacted. Alternatively, those that spend more on fuel, travel or eating out may experience a more pronounced impact from inflation on their purchasing power.

Your current investment objective is also a consideration. Those that are more reliant on their portfolio for income are going to have a more immediate sensitivity to the impact of inflation. Alternatively, individuals that are still working and whose liabilities are further into the future don’t need their portfolio to immediately respond to any inflationary pressures.

Inflation Fighting Solutions

Unfortunately, there is no easy one-size-fits-all solution to bulletproof a portfolio against inflation. There have been a limited number of historic episodes of inflation, and no outsized inflationary periods since the early 1980’s. Newer asset classes such as infrastructure and emerging market debt don’t have histories going back this far and thus it is harder to conduct a robust statistical analysis with limited or incomplete data. In addition, some assets have exhibited persistent success in generating returns in periods of inflation, while others have been more episodic. Making the analysis even more challenging is the fact that those assets that have greater persistence in fighting inflation tend to be more volatile and carry greater opportunity costs in periods where there is subdued inflation or deflation.

Assets that have tended to persistently perform well during bouts of inflation (to varying degrees) are commodities, Treasury Inflation Protected Securities (TIPS), and gold. Other assets, such as foreign currencies, natural resource equities and real estate have performed well during some inflationary episodes but not all. How these assets have traded leading up to the inflationary episode and whether underlying market conditions are favorable for the specific asset can be impactful in how they perform during a particular inflationary environment.

Commodities have historically been highly sensitive to inflation, and for good reason. As inflation rises, the prices of items such as copper, corn, lumber, and oil are able to quickly respond. Thus far in 2021 we’ve seen strong performance out of commodities, with some, such as lumber and copper, experiencing a meteoric rise. The challenge with commodities is that they are incredibly hard to time and can be exceptionally volatile. These periods of boom and bust for commodities have led to long-term risk adjusted returns appearing less appealing relative to traditional stocks and bonds.

TIPS seem like an easy and straight forward approach to protecting against inflation. The attraction to TIPS is that the interest payment, or coupon, adjusts in tandem with the Consumer Price Index (CPI). In one sense investors are hedged because higher inflation means higher coupon payments. The one drawback is a key input in the price of a TIP bond is its yield. If interest rates rise as the CPI increases, the price of the bond could fall (as bond prices move opposite interest rates). The decrease in price could serve as an offset the added returning stemming from the increased coupon.

Gold is another asset that over time has served as an effective inflation hedge. Gold is also viewed as a safe haven asset with some also seeing it as insurance against a weakening U.S. dollar. Gold can be challenging as it does not produce any cash flows. Hence higher interest rates create a greater opportunity cost in holding gold as you don’t get any cash flows, whereas owning an alternative low risk asset like a Treasury bond could lead to some return through cash interest payments. Therefore, while gold over time has historically served as an effective inflation hedge, it may not always move in tandem with inflation depending on the direction of the dollar or based on the level of interest rates.

Other assets have had erratic experience in protecting against inflation. Real Estate (REITs) tend to benefit from inflation as landlords are able to reprice rents. There is, however, typically a lag with this as rents can’t be raised until leases come due. As such, REITs have served as a reasonable intermediate term hedge against inflation, but not always in the short-term. Investing in foreign currencies can be beneficial in inflationary periods, however, high inflation globally may limit return differentials across currencies. Individual equities of natural resource companies, such as oil or basic material businesses, have often done well in inflationary environments. These stocks can also succumb to multiple contraction, but ideally during inflationary times may be better able to absorb this headwind given that they may also experience outsized growth in revenue and earnings.

What we haven’t mentioned yet are stocks and bonds. Stocks have historically had mixed results, as there are competing factors in how inflation impacts their valuation. A positive impact of inflation is that higher prices will lead to higher revenue and earnings. Putting this in context of a stock’s price-to-earnings ratio, or P/E, rising earnings would be a positive. The offset, however, is that P/E multiples have historically tended to fall during bouts of inflation. For example, take a company that generated $1 of earnings and its stock traded at 20x P/E multiple prior to a rise in inflation. If P/E multiples compressed to 15x, the company’s earnings would need to grow to $1.33 in order for the share price to tread water. Over time, this likely works itself out, but in the short-term, equities may be at risk from contracting multiples during episodes of inflation.

Higher inflation has tended to be a challenge for bond prices for a number of reasons. First, the prospect of higher inflation is likely to lead to higher interest rates. Higher rates are a negative for bond prices. Second, as investors become concerned about inflation, they may choose to sell bonds and reallocate to assets they perceive to be a better hedge against inflation.

Assessing your Portfolio

As we noted in our prior article, near-term we see the prospect for higher inflation, but don’t yet see signs that we will experience hyperinflation. However, given the pace of the economic recovery and the significant increase in monetary supply, we wouldn’t be surprised to see inflation exceed the Fed’s 2% target over the next year or so. Listed below are some things we believe investors should consider in a more moderate inflationary environment.

• Be cognizant of what your vulnerability to inflation actually is. If you are a long-term investor and aren’t yet reliant on your portfolio to provide income, inflation may be less of a risk.
• For investors reliant on generating income from their portfolio, understand that inflation might lower your purchasing power. Your advisor can help you better understand your sensitivity to inflation.
• Owning direct inflation fighting assets such as commodities, TIPS or gold may be prudent. However, these can add volatility and downside risk to your portfolio. The entry point on these investments may also prove important.
• Consider allocating to other assets that have historically had some success during past inflationary episodes. These assets could include currency, real estate, infrastructure and natural resource stocks.

PAST PERFORMANCE IS NOT A GUARANTEE OF FUTURE RESULTS. This material is presented solely for information purposes and has been gathered from sources believed to be reliable, however Telemus cannot guarantee the accuracy or completeness of such information, and certain information may have been condensed or summarized from its original source. The views expressed herein represent the views of Telemus at the time of writing this piece and are subject to change at any time. Investment decisions should always be made based on the client's specific financial needs, goals and objectives, time horizon and risk tolerance. Current and future portfolio holdings are subject to risk. Risks may include interest-rate risk, market risk, inflation risk, deflation risk, currency risk, reinvestment risk, business risk, liquidity risk, financial risk, and cybersecurity risk. These risks are more fully described in Telemus Capital's Firm Brochure (Part 2A of Form ADV), which is available upon request. Telemus Capital does not guarantee the results of any investments. Investment, insurance and annuity products are not FDIC insured, are not bank guaranteed, and may lose value. The Consumer Price Index (CPI) measures the performance of US inflation (not seasonally adjusted) which is the rate of change of consumer goods prices. The data is from Bureau of Labor Statistics. The value of the current month CPI is estimated by the average value of the previous two months CPI. An index is not a security in which an investment can be made, as they are unmanaged vehicles that serve as market indicators only. It should not be assumed that portfolio holdings will correspond directly to any of the comparative index benchmarks. Advisory services are only offered to clients or prospective clients where Telemus and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Telemus unless a client service agreement is in place.