A whitepaper by Penton Financial Services highlights the need for advisors to talk about inflation while interacting with their clients. The paper explores the impact that higher inflation could have on assets.
According to the paper, inflation should be a critical investment consideration for three key reasons. The first reason being that inflation erodes purchasing power. “Inflation does not need to be high or rising to represent a risk to an investment strategy; it should be a key consideration for managing portfolio risk in any scenario,” it says.
The second reason for considering inflation is that rising inflation has historically been a drag on equity and bond returns. “Stocks and bonds do not historically perform as well during periods when inflation is rising for an extended period of time (at least six months). Although inflation may provide a boost to stocks by increasing company revenues, it can also impair valuations when higher rates are used to discount earnings. Increasing revenues may also be offset by simultaneous increases in costs,” says the paper.
The third reason is that higher inflation makes diversifying beyond mainstream asset classes more essential. “Bond returns tend to have a low or even negative correlation with stock returns when inflation is low. By contrast, when inflation is higher and more volatile the correlation between stocks and bonds increases. Because rising inflation negatively affects the performance of both stocks and bonds, bonds generally become more equity-like amid higher inflation and thus tend to provide less diversification,” says the whitepaper.
Mitigating inflation risks
According to the paper, investors will be able to mitigate inflation risks by investing in asset categories that perform better in such situations. Although the performance of the major asset classes tends to deteriorate when inflation is on the rise, the paper points at two asset-class subcategories that have historically held up better in such environments.
The first subcategory contains assets with long histories of reliable returns that, on average, outperform when inflation is rising like commodities, gold, commodity-producing equities, short-duration bonds, etc.
The second subcategory consists of other asset classes with shorter histories of returns that make long-term analysis more difficult. However, the paper’s analysis suggests that their underlying properties would have also provided them with more resistance against rising inflation over the long term than the major asset classes like REITs, treasury inflation-protected securities (TIPS) and leveraged loans.
Although these asset categories have trailed the broader stock and bond markets amid falling inflation, they have outperformed when inflation has risen, says the whitepaper.
Considering a proper allocation plan
While the proper allocation to inflation-resistant assets is highly dependent on each investor’s unique circumstances and investment strategy, the whitepaper says, “The most appropriate way to manage inflation risk will therefore be highly dependent on both the perceived risk of higher inflation and the key considerations unique to each investor and investment strategy.”
Therefore, a strategic allocation to a basket of inflation resistant assets, such as commodities, commodity producing equities, gold, short-duration bonds, and possibly REITs, TIPS, and/or leveraged loans, may help these investors manage the risk that inflation could be higher than anticipated over the long term.
