Given the uncertain state of the economy in recent years, it’s no surprise that many clients come to us with concerns about inflation and, specifically, with questions about how inflation might affect their comprehensive financial plan.
While we reassure our clients with the good news that inflation isn’t likely to be a concern in the near-term, the long-term outlook is a bit more troublesome. Fortunately, there are well-documented ways to minimize inflation’s negative impact.
Inflation, Stock Prices and Strategic Wealth Planning
Views on the relationship between inflation and stock prices vary, but one thing is clear: Inflation is just one of many factors driving stock performance. In fact, Dimensional Fund Advisors, one of the nation’s leading institutional asset class fund provider, notes that “US market history since 1926 shows that nominal annual stock returns are unrelated to inflation.”
That said, evidence indicates that the price people are willing to pay for stocks -- the price-to-earnings (PE) ratio -- is inversely related to the rate of inflation. Historically, when the inflation rate is below 6%, the market has traded at significantly higher PE ratio. In other words, when people are optimistic and thus willing to pay more for stocks, we experience a positive environment for market returns.
Conversely, when the inflation rate climbs above 6%, the PE ratio drops, creating a more challenging environment. If inflation rises significantly in the future, expect lower PE ratios and a tougher time for the equity markets. In addition, economists note that high inflation often coincides with heightened economic uncertainty and greater risk aversion, neither of which bode well for the equity markets.
Inflation and Bond Prices
Then there’s the bond market, in which inflation is public enemy number one. When inflation rises, so do interest rates. Interest rates and bond prices are inversely related causing bond prices to decline.
To make matters worse, inflation tends to erode the principal value of bond holdings over time. At a 4% inflation rate, a dollar is cut in half every 18 years. This means that the future purchasing power of your initial investment can be reduced by half – or more – over the life of a longer dated bond.
Strategies for Your Wealth Managment Plan
So what can the average investor do to protect themselves from the potential risks posed by inflation and maintain peace of mind in the face of uncertainty? Two main strategies exist:
Hedging inflation’s immediate effects
Earning a total return that outpaces inflation over time
Your risk tolerance, investment goals and age determine which is most appropriate.
Hedging, or choosing assets with values that rise with inflation, may be an option for retirees who depend on portfolios to meet living expenses, fixed income investors, and those who would experience a diminished standard of living during an inflationary period.
An appropriate inflation hedge is an asset that:
Has moderate inflation-adjusted or real returns
Is low risk (minimal variability of real returns)
Has low correlation with other assets negatively impacted by inflation (a dissimilar price movement than stocks and bonds)
When considering inflation hedges, many look to gold, oil and commodities; while these assets indeed correlate to inflation, they are also high risk and experience much greater annual price fluctuations than do the stock markets over time.
In contrast, short-term treasuries and treasury inflation protection securities (TIPS) are effective, minimal-risk inflation hedges that produce positive, inflation-adjusted returns while controlling risk. They exhibit low correlation to traditional assets, like stocks and corporate bonds, thus increasing portfolio diversification.
The Total Return Strategy: An Asset Management Solution
The total return strategy attempts to outpace inflation through assets most likely to produce strong inflation-adjusted returns over the long term, such as stocks. Such assets possess higher volatility and more near-term sensitivity to inflation.
Total return strategy candidates include younger investors with earnings capacity and time to recoup any short-term inflation-related losses, investors managing assets for the next generation, and asset pools with long time horizons, such as endowments, scholarship funds and foundations.
Since the time of reliable market data (1926), stocks returns have outpaced inflation by more than 6% a year. Of course, premium returns come with higher risk, making a significant stock allocation more appropriate for a long-term, rather than a short-term, hedge
A Bit of Perspective in Investment Planning
Remember that, in the short-term, markets react to news about inflation. If that news is negative, stock and bond prices will reflect this reality, and vice-versa.
Instead, consider the following:
Whether an inflation hedging or total return strategy is most appropriate for you
Review your fixed income allocation and identify your exposure to inflation risk
Accept that many supposed inflation hedges are highly volatile
We feel that the stock market already reflects current views about inflation, so making aggressive portfolio changes around headlines and hype simply doesn’t make sense for an investor who is interested in following through on their long-term investment strategy.