Earlier this month, when the Bureau of Labor Statistics released its Consumer Price Index report for July 2021, headlines reported year-over-year inflation clocking in at 5.4% for the second straight month. This got many retirement investors asking questions about the impact of inflation on their portfolios.
Asking questions is OK. Asking the wrong questions isn’t.
“Because ‘inflation’ is all over the news right now, many investors are trying to find ways to take on inflation and sometimes they get too creative, which can have adverse effects,” says Mike Cocco, Equitable
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One of the first questions you should ask is “What’s the cause of the inflation we’re experiencing right now?” This might help you better prepare your investments properly for any long term impact inflation may have.
“Inflation’s headline causes typically are in fact different,” says John P. Micklitsch, Chief Investment Officer at Ancora in Cleveland. “For example, we’ve never had something like Covid before on a global basis. But inflation, in its simplest form, usually comes down to a mismatch between supply and demand. The question becomes the length of time it takes to resolve the mismatch. Will it be measured in months, quarters, years or even decades? No one exactly knows for sure, but a well-diversified, high-quality portfolio should be able to accommodate any of these scenarios. Then it just comes down to saving judiciously and a focus on time in the market as opposed to trying to time the markets. That, and an optimistic, long-term outlook are the best ingredients for success and advice that we can offer investors, including plan participants.”
Beyond what you’re reading, the reaction of the various markets can offer some insights on expectations regarding inflation. They are key barometers which might suggest what mistakes you should avoid.
“The details are always different,” says Derek S. Taddei, Relationship Manager, 401k Specialist at HoyleCohen, LLC in Phoenix. “Today, inflation is making the headlines due to significant year-over-year differences between Pandemic Lows of March/April 2020 and the present. The rate of change will likely subside as we re-enter more normal times, and we will find the inflation winds to be transitory. While newspaper and online headlines are all about price increases and inflation, the bond market has a different take as longer-term bonds yields remain subdued.”
We haven’t seen this level of inflation in quite some time. Even though it’s short-term (right now), that doesn’t mean many won’t experience a knee-jerk reaction. Ironically, this can lead to the very results that you are trying to avoid.
“Some investors, when they feel uneasy, their natural instinct is to get more conservative and hold on to more cash or bonds, for safe keeping,” says Cocco. “If their goal is to combat inflation, that is one of the worst things you can do. With interest rates on cash and bonds near historic lows, by holding too much cash or bonds, you are essentially guaranteeing yourself that you will not earn enough interest to keep pace with inflation, so you could be losing purchasing power over time, which is the opposite of fighting inflation.”
Even so-called “Treasury Inflation Protected Securities” (or “TIPS”) can produce unintended results in certain circumstances.
“Investors may be quick to buy TIPS if they fear inflation is going to increase,” says Steven Saunders, Director, Portfolio Advisor with Round Table Wealth Management in New York City. “As the name would suggest, coupon payments on these bonds do adjust based on inflation but that is only part of the potential return. The other portion of the return is the ‘real yield,’ which is the yield on a nominal Treasury bond less the implied inflation. TIPS outperform nominal bonds when the real yield is declining, meaning inflation expectations are increasing faster than nominal rates in a rate rising environment. However, if nominal yields increase at a faster pace than inflation expectations, a TIPS investor can actually lose money as real yields rise. This scenario can happen even if inflation is at elevated levels so long as nominal yields are also at elevated levels.”
If some people react to inflation in a too conservative fashion, others flee to the other extreme. Here, it’s important to stay focused on your own Goal-Oriented Target
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“One mistake that investors make when trying to fight inflation is actually taking on too much risk in their portfolios,” says Mike Windle, CEO at Custom Wealth Solutions in Plymouth, Michigan. “Every investor should know their own personalized rate of return need and should build and manage their portfolio to that return. Also, when inflation becomes a topic of discussion, you begin to hear a lot about buying gold. Many people believe that gold is a great inflation hedge when in reality there is nothing inherent to the price of gold that is tied to inflation. Gold only works as a hedge to the extent that people believe that it is and then act on that belief.”
Rather than get too excited about inflation, it’s better to understand what it really means for your investment objective.
“Inflation simply increases the hurdle rate for investors, meaning that with higher inflation, an investor has a higher breakeven rate of return level to preserve the purchasing power of their money,” says Taddei. “To do that, an investor has to play offense. Hiding in money markets until inflation subsides is not playing offense, and that is but one of the strategic mistakes investors can make. Company revenues and earnings include inflation, meaning that for many companies, inflation increases reported revenues and if managed correctly earnings as well.”
You should also consider broader policy responses to inflation that could have an impact on your investments. These decision-makers have ready access to historical data to help guide their moves.
“The world is just beginning to emerge from an unprecedented shock to financial markets and our personal lives,” says Saunders. “It is hard to argue against ‘this time is different,’ but there are past periods of elevated inflation that many may try to draw analogies. The worst of which was in the 1970s when inflation peaked in the mid-teens. While similarities may be drawn from higher inflation due to increased government spending and high unemployment, the results were due to years of policy missteps that allowed inflation to continue to increase over the years. It is hard to see the same mistakes happening again as the Federal Reserve has communicated an average inflation target of 2%, meaning that if inflation does stay elevated for an extended period, they would likely take actions to limit further increases.”
Of course, not all actions out of Washington are reliably helpful. Some can themselves serve as the same kind of overreaction that individuals are susceptible to.
“The Federal Reserve has said that it will continue with its quantitative easing program until inflation is maintaining a level consistently above 2%,” says Windle. “What we are beginning to see however is that it appears that inflation will find its way higher than the Federal Reserve target. This may be exasperated by continued stimulus programs when markets are at or near all-time highs and are showing signs of having made a full recovery. This leads to the thought that we could see inflation over 4% for the year.”
Rest assured that markets and economies repeat themselves over time. More often than not, while “this time it’s different” may be true when you drill down to the precise details, the general tendencies and outcomes remain remarkably similar.
“As history has shown us, we go through cycles all the time, but the end result is pretty much the same,” says Cocco. “If you are a long-term investor, you must have an allocation to equities if you want to keep pace with, and exceed inflation. Yes, in the short-term, the markets and the economy will do some things that no one sees coming, and things we feel like we are not prepared for, but having a strategy that you can stick to, to outlast any of the uncertain times, will give you the best chance of success. Sometimes, spikes in inflation and interest rates cause panic and losses in the short-term, but if you are a long-term investor, those periods of peril can also provide opportunities, so welcome those times if you are a long-term investor and stick to your strategy.”
If you want to live happily ever after, you shouldn’t get too worried about inflation. When you do worry, remember, it’s that emotional response that can lead you down a mistaken path.