Inflation Risk: Is the Wolf at the Door?

Who’s afraid of big, bad inflation? A lot of people are, and not entirely without reason. With the economy starting to recover from the COVID-19 pandemic, media outlets and investor concerns have been turning increasingly toward inflation risk.  

We all know the Federal Reserve (“the Fed”) has been injecting trillions of dollars of borrowed money into the economy. A national thirst for rebuilding infrastructure and digging out of COVID-19 is leaving our federal coffers—as well as many state and local balance sheets—with the biggest public-debt load as a percentage of gross domestic product (GDP) since World War II. Most other Western nations have been following suit.  

What could possibly go wrong? At least with respect to your investments, the answer is, inflation. If there’s enough geopolitical pressure to keep interest rates lower for longer, while debt continues to rise, the Fed may let inflation run higher than its stated, traditional 2% target. Maybe a lot higher. If inflation does take off, it could take a big bite out of your real rates of return. 

Or not. 

So far, there have been no extreme inflationary risks realized. In its March 2021 “Long Term Budget Outlook,” the U.S. Congressional Budget Office found “no set tipping point at which a [debt-to-GDP] crisis becomes likely or imminent.” While we are in no way predicting all is well, neither is there evidence that it’s time to panic:  

• The strength of the U.S. dollar: This recent Wall Street Journal piece suggests a degree of confidence may be well placed, given a continued volume of “foreign investors who are happy to park their cash in the U.S.” 
• Global response: We’re also seeing evidence that other governments are trying to rein in their debt-to-GDP ratios. In November 2020, British finance minister Rishi Sunak described the U.K.’s public finance path as “unsustainable” over the long-term. 
• Economic analysis: As we’ll cover below, many economists are not yet crying “Wolf!” either over the threat of rising inflation. 

Let’s put these pieces together, and examine what it means to your evidence-based investment strategy. If you’d rather not read the entire explanation, our conclusion remains constant: As usual, we recommend ignoring fast-breaking economic forecasts, and focusing instead on maintaining a globally diversified portfolio based on your personal goals and risk tolerances. Admittedly, this isn’t the most entertaining advice in the world, but it beats guessing where your best financial interests are found.    

Should We Worry About Inflation?

“We haven’t been in a period of high inflation, or even moderate inflation, for at least 10 years,” says Gene Fama. Professor Fama and Dimensional’s David Booth discussed inflation recently. “I’m not particularly concerned that inflation will be high soon.” The exchange can be found HERE.  

One way to think about inflation is this: when the prices of goods and services increase over time, consumers can buy fewer of them with every dollar they have saved. This erosion of the real purchasing power of wealth is called inflation. Inflation is an important element of investing. In many cases, the reason for saving today is to support future spending. Therefore, keeping pace with inflation is a crucial goal for many investors. 

Many economists like Merton Miller, PhD, believe market prices lay out the case for what the market expects. Miller has said, ““Everybody has some information. The function of the markets is to aggregate that information, evaluate it, and get it incorporated into prices.”

The market does not seem to be bracing for wild inflationary extremes, despite the significant government spending and borrowing already underway. 

So, what is the market expecting? Let’s look to the markets and prices of certain securities for some insight. Often, consensus for future inflation can be measured by the 10-Year Breakeven Inflation Rate. This is the rate at which you’d receive the same total return whether you invested in Treasury Inflation-Protected Securities (TIPS) or Treasury bonds, while assuming average expected inflation for the next 10 years.  

In other words, the 10-Year Breakeven Inflation Rate represents the market’s best guess at what’s coming next. Although this makes the consensus a fuzzy forecast, it suggests the market was expecting an inflation rate of 2.46% as of June 1, 2021.  A touch high, but not scary-high.  

Source: Federal Reserve Bank of St. Louis FRED Economic Data

Diversified Investing in Inflationary Times

Tempered by the preceding points, inflationary risks remain. The market is fickle, continuously processing and quickly reacting to the latest information. We like to speak in risks you can control and those you cannot.  

So, let’s say inflation remains, or even takes off in the months or years ahead. What’s an investor to do? 

First, remember what you CANNOT do: Unless you’re a member of the Federal Reserve, you cannot have an impact on inflation. In fact, even the Fed can only do so much. Instead, focus on what you CAN do. In a word, that’s diversification. Inflation and other risks routinely happen. So, building and maintaining a globally diversified investment portfolio remains your best “lever” to: 

(1) Protect what you’ve accumulated against the worst-case possibilities, while …

(2) Participate wherever and whenever the next best-case investment outcomes may strike. 

With that in mind, let’s review some of your best opportunities to diversify.  

Equity

When it comes to diversification, step one is to buy and hold a well-diversified basket of equities. Over the long run, stocks should outpace inflation by far, to provide your best inflation hedge. This is especially the case if you diversify globally, and into the risk factors that are expected to yield higher returns (such as small-cap and value stocks). Consider the following:

1. Inflation: Thanks to a long-term average inflation rate of 2.97%, the goods and services you could purchase for $1 in 1926 would cost you more than $15 today.
2. U.S. stocks: What if you could have invested that same $1 in something like a U.S Large Capitalization Index back in 1926? Assuming reinvested dividends and an annualized return of just over 10%, your $1 at the end of 2020 would now be worth $10,937.
3. U.S. small-cap stocks: The same $1 diversified into U.S. small-cap stocks beginning in 1926 would now be worth more than $32,817.

As the value of a dollar declines over time, investing can help grow wealth and preserve purchasing power. Investors should know that over the long-haul stocks have historically outpaced inflation, but there have also been short-term stretches where this has not been the case. This makes a compelling argument for why equities should be included in a diversified portfolio to meet the goal of preserving long-term purchasing power for your assets. 

Note that past returns are not guaranteed and anyone who tells differently is lying to you. 

 

Fixed Income

In tandem with your diversified equity portfolio, your second course of action is to review your fixed income composition.  When considering future consumption, one of the primary goals for investors may be the preservation of their purchasing power. Among many things, purchasing power can be affected by the real return of an investor’s fixed income portfolio. For instance, if the real return of the portfolio—the return the investor receives after inflation—is negative, purchasing power may be eroded, leaving a gap between the investor’s wealth and liabilities. Annual inflation in the US has been positive in 83 of the last 90 years and has not been negative since 1954.

Inflation erodes bond returns in general, and typically even more aggressively as bond maturity increases. For example, if a 30-year Treasury bond yields 4%, but inflation averages 6% annually during the same period, you lose 2% per year in real (net-of-inflation) terms across the entire 30 years. As this short Dimensional video explains, even short-term bonds can have exposure to inflation risk. Their returns have barely outpaced inflation historically, so they are an imperfect inflation hedge. Here are a couple of possibilities for addressing these issues:  

1. Ladder It: If you have a relatively large fixed income allocation (starting at $500,000 or more), you can own a ladder made of individual bonds to take advantage of higher rates as inflation rises. With a regular and steady flow of bonds maturing each year, you can reinvest into the higher rates to combat rising inflation.
2. Take on TIPS: Another option is to allocate a portion of your bond portfolio to short-term Treasury Inflation-Protected Securities known as TIPS. The short duration allows TIPS to respond to rising/falling inflation so, at least pre-tax, they are the only securities that are essentially guaranteed to outpace inflation. 

 Note, however, investing in TIPS and other fixed income instruments can have tax ramifications, which we help our clients factor in as we devise a strategy that works best for their needs. 

Alternatives 

 An investor may use alternative strategies for a modest portion of their overall allocation. Academic research has uncovered the benefits that some alternative strategies can add by either enhancing portfolio diversification or improving expected return. The alternative investment strategies we use in our and our client’s portfolios are held in mutual fund form. We recommend modest allocations since these strategies have higher expenses, are typically less tax efficient and the interval fund alternatives are not liquid.

There are many possibilities here, include alternative lending, reinsurance, and commodities and alternative lending investments. Commodities have tended to do well when inflation is higher than expected. Other funds may provide some inflation protection by holding very short-term notes, or offering a floating rate.  

Some examples: 

• The Stone Ridge Alternative Lending Risk Premium Fund (LENDX) offers exposure to consumer and small business loans, which have historically been profitable for banks. 
• The Cliffwater Corporate Lending Fund (CCLFX) is a closed‐end interval fund providing interest income from a portfolio of loans to U.S. middle‐market companies. The companies are originated and managed by non‐bank lenders selected by Cliffwater LLC, an institutional alternatives firm with over $77 billion in assets under advisement. 
• Stone Ridge Reinsurance Risk Premium Interval Fund (SRRIX) or the Stone Ridge High Yield Reinsurance Fund (SHRIX) attempts to deliver exposure to the reinsurance risk premium. 
• AQR Style Premia Fund (QSPRX) which seeks to deliver value, momentum, carry and quality premiums across multiple asset classes. 

Note, a discussion of LENDX, CCLFX, SRRIX, SHRIX or QSPRX is provided for informational purposes only and is not intended to serve as specific investment or financial advice. This list of funds does not constitute a recommendation to purchase a single specific security, and it should not be assumed the securities referenced herein were or will prove to be profitable. Prior to making any investment, an investor should carefully consider the fund’s risks and investment objectives and evaluate all offering materials and other documents associated with the investment.

Cryptocurrency

While we caution against getting caught up in a cryptocurrency craze, it is possible that a small cryptocurrency allocation may offer diversification during inflationary times.  The theory is untested, but some have projected cryptocurrency could do well during high inflation. So, if you’re highly risk tolerant and comfortable speculating with a portion of your portfolio (to be clear: you could lose it all!), you may consider a position in Bitcoin (BTC) or a similar holding.  

Building Your Portfolio Out of Anti-Inflation Bricks

So, is big, bad inflation at our door? Time will tell. If it arrives, what should you do? To create your strongest defense, you must diversify. Diversify your equities, across risk factors and internationally. Diversify into and across your fixed income holdings. Consider additional diversification into alternative investments. Once you’ve created your globally diversified portfolio, sit tight with it when risks arise to huff and puff at what you’ve built. 

Inflation is an important consideration for many long-term investors. By combining the right mix of growth and risk management assets, investors may be able to blunt the effects of inflation and grow their wealth over time. Remember, however, that inflation is only one consideration among many that investors must contend with when building a portfolio for the future. 

We align our thinking with David Booth’s in the article mentioned above when it comes to risk: “I think part of planning is not only your investment portfolio, but what to do if you experience unexpected events of any kind.” This includes unexpected spikes of inflation.

Booth states, ‘“Control what you can control.” You can’t control markets. What you can do is prepare yourself for what you’ll do in case bad events happen. Inflation is just one of many risk factors long-term investors need to be prepared for.’

If you want to know more about how independent advice can help you defend against inflationary risks on the way to your financial goals, we hope you’ll sit down with our team today for a Cogent Conversation.  

We’ll listen to what success looks like for you, build a plan tailored to you, discuss options for you to limit the volatility in your portfolio and risk of loss of purchasing power, and help you execute that plan every step of the way. We will advise on how inflation risks can be mitigated within a portfolio, and also how best to protect your retirement savings to improve your overall plan.

Life is uncertain. The market is even more precarious. This means building wealth has no shortcuts. Success requires a solid investment approach, a long-term perspective, and discipline to stay the course. Instead of leaving your financial future to chance, you need to have a plan. 

Cogent Strategic Wealth is here for you. 

So, instead of worrying about your future, why not take positive steps to protect it? Set up a Cogent Conversation with us today. We’ll show you how to transform your hard work into durable wealth even through troubling markets. 

SCHEDULE A CALL WITH ONE OF OUR WEALTH ADVISORS

The opinions expressed by featured authors are their own and may not accurately reflect those of Cogent Strategic Wealth®. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

© 2021, Cogent Strategic Wealth®

 

 

 

 

 

 

 

 

Our Thinking on Inflation Risk: Is the Wolf at Your Door?

 

Who’s afraid of big, bad inflation? A lot of people are, and not entirely without reason. With the economy starting to recover from the COVID-19 pandemic, media outlets and investor concerns have been turning increasingly toward inflation risk. 

 

We all know the Federal Reserve (“the Fed”) has been injecting trillions of dollars of borrowed money into the economy. A national thirst for rebuilding infrastructure and digging out of COVID-19 is leaving our federal coffers—as well as many state and local balance sheets—with the biggest public-debt load as a percentage of gross domestic product (GDP) since World War II. Most other Western nations have been following suit. 

 

What could possibly go wrong? At least with respect to your investments, the answer is, inflation. If there’s enough geopolitical pressure to keep interest rates lower for longer, while debt continues to rise, the Fed may let inflation run higher than its stated, traditional 2% target. Maybe a lot higher. If inflation does take off, it could take a big bite out of your real rates of return.

 

Or not. 

 

So far, there have been no extreme inflationary risks realized. In its March 2021 “Long Term Budget Outlook,” the U.S. Congressional Budget Office found “no set tipping point at which a [debt-to-GDP] crisis becomes likely or imminent.” While we are in no way predicting all is well, neither is there evidence that it’s time to panic: 

 

• The strength of the U.S. dollar: This recent Wall Street Journal piece suggests a degree of confidence may be well placed, given a continued volume of “foreign investors who are happy to park their cash in the U.S.” 
• Global response: We’re also seeing evidence that other governments are trying to rein in their debt-to-GDP ratios. In November 2020, British finance minister Rishi Sunak described the U.K.’s public finance path as “unsustainable” over the long-term. 
• Economic analysis: As we’ll cover below, many economists are not yet crying “Wolf!” either over the threat of rising inflation. 

 

Let’s put these pieces together, and examine what it means to your evidence-based investment strategy. If you’d rather not read the entire explanation, our conclusion remains constant: As usual, we recommend ignoring fast-breaking economic forecasts, and focusing instead on maintaining a globally diversified portfolio based on your personal goals and risk tolerances. Admittedly, this isn’t the most entertaining advice in the world, but it beats guessing where your best financial interests are found.    

 

Much Ado About Inflation

 

“We haven’t been in a period of high inflation, or even moderate inflation, for at least 10 years,” says Gene Fama. Professor Fama and Dimensional’s David Booth discussed inflation recently. “I’m not particularly concerned that inflation will be high soon.” The exchange can be found HERE. 

 

One way to think about inflation is this: when the prices of goods and services increase over time, consumers can buy fewer of them with every dollar they have saved. This erosion of the real purchasing power of wealth is called inflation. Inflation is an important element of investing. In many cases, the reason for saving today is to support future spending. Therefore, keeping pace with inflation is a crucial goal for many investors.

 

Many economists like Merton Miller, PhD, believe market prices lay out the case for what the market expects. Miller has said, ““Everybody has some information. The function of the markets is to aggregate that information, evaluate it, and get it incorporated into prices.”1

 

The market does not seem to be bracing for wild inflationary extremes, despite the significant government spending and borrowing already underway. 

 

So, what is the market expecting? Let’s look to the markets and prices of certain securities for some insight. Often, consensus for future inflation can be measured by the 10-Year Breakeven Inflation Rate. This is the rate at which you’d receive the same total return whether you invested in Treasury Inflation-Protected Securities (TIPS) or Treasury bonds, while assuming average expected inflation for the next 10 years. 

 

In other words, the 10-Year Breakeven Inflation Rate represents the market’s best guess at what’s coming next. Although this makes the consensus a fuzzy forecast, it suggests the market was expecting an inflation rate of 2.46% as of June 1, 2021.[WC1]  A touch high, but not scary-high. 

 

 

Source: Federal Reserve Bank of St. Louis FRED Economic Data (https://fred.stlouisfed.org/series/T10YIE) 

 

Diversified Investing in Inflationary Times

 

Tempered by the preceding points, inflationary risks remain. The market is fickle, continuously processing and quickly reacting to the latest information. We like to speak in risks you can control and those you cannot.  

So, let’s say inflation remains, or even takes off in the months or years ahead. What’s an investor to do? 

 

First, remember what you CANNOT do: Unless you’re a member of the Federal Reserve, you cannot have an impact on inflation. In fact, even the Fed can only do so much. Instead, focus on what you CAN do. In a word, that’s diversification. Inflation and other risks routinely happen. So, building and maintaining a globally diversified investment portfolio remains your best “lever” to: 

 

(1) Protect what you’ve accumulated against the worst-case possibilities, while …

(2) Participate wherever and whenever the next best-case investment outcomes may strike. 

 

With that in mind, let’s review some of your best opportunities to diversify. 

 

Equity 

When it comes to diversification, step one is to buy and hold a well-diversified basket of equities. Over the long run, stocks should outpace inflation by far, to provide your best inflation hedge. This is especially the case if you diversify globally, and into the risk factors that are expected to yield higher returns (such as small-cap and value stocks). Consider the following:

 

1. Inflation: Thanks to a long-term average inflation rate of 2.97%, the goods and services you could purchase for $1 in 1926 would cost you more than $15 today.
2. U.S. stocks: What if you could have invested that same $1 in something like a U.S Large Capitalization Index back in 1926? Assuming reinvested dividends and an annualized return of just over 10%, your $1 at the end of 2020 would now be worth $10,937.
3. U.S. small-cap stocks: The same $1 diversified into U.S. small-cap stocks beginning in 1926 would now be worth more than $32,817.

 

As the value of a dollar declines over time, investing can help grow wealth and preserve purchasing power. Investors should know that over the long-haul stocks have historically outpaced inflation, but there have also been short-term stretches where this has not been the case. This makes a compelling argument for why equities should be included in a diversified portfolio to meet the goal of preserving long-term purchasing power for your assets. 

 

Note that past returns are not guaranteed and anyone who tells differently is lying to you. 

 

 

 

Fixed Income

In tandem with your diversified equity portfolio, your second course of action is to review your fixed income composition. 

 

When considering future consumption, one of the primary goals for investors may be the preservation of their purchasing power. Among many things, purchasing power can be affected by the real return of an investor’s fixed income portfolio. For instance, if the real return of the portfolio—the return the investor receives after inflation—is negative, purchasing power may be eroded, leaving a gap between the investor’s wealth and liabilities. Annual inflation in the US has been positive in 83 of the last 90 years and has not been negative since 1954.

 

Inflation erodes bond returns in general, and typically even more aggressively as bond maturity increases. For example, if a 30-year Treasury bond yields 4%, but inflation averages 6% annually during the same period, you lose 2% per year in real (net-of-inflation) terms across the entire 30 years. As this short Dimensional video[WC2]  explains, even short-term bonds can have exposure to inflation risk. Their returns have barely outpaced inflation historically, so they are an imperfect inflation hedge. Here are a couple of possibilities for addressing these issues: 

 

1. Ladder It: If you have a relatively large fixed income allocation (starting at $500,000 or more), you can own a ladder made of individual bonds to take advantage of higher rates as inflation rises. With a regular and steady flow of bonds maturing each year, you can reinvest into the higher rates to combat rising inflation.
2. Take on TIPS: Another option is to allocate a portion of your bond portfolio to short-term Treasury Inflation-Protected Securities known as TIPS. The short duration allows TIPS to respond to rising/falling inflation so, at least pre-tax, they are the only securities that are essentially guaranteed to outpace inflation. 

 

Note, however, investing in TIPS and other fixed income instruments can have tax ramifications, which we help our clients factor in as we devise a strategy that works best for their needs. 

 

Alternatives 

 

An investor may use alternative strategies for a modest portion of their overall allocation. Academic research has uncovered the benefits that some alternative strategies can add by either enhancing portfolio diversification or improving expected return. The alternative investment strategies we use in our and our client’s portfolios are held in mutual fund

form. We recommend modest allocations since these strategies have higher

expenses, are typically less tax efficient and the interval fund alternatives are not liquid.

 

There are many possibilities here, include alternative lending, reinsurance, and commodities and alternative lending investments. Commodities have tended to do well when inflation is higher than expected. Other funds may provide some inflation protection by holding very short-term notes, or offering a floating rate. 

 

Some example[WC3] s:

 

1. The Stone Ridge Alternative Lending Risk Premium Fund (LENDX) offers exposure to consumer and small business loans, which have historically been profitable for banks. 

 

1. The Cliffwater Corporate Lending Fund (CCLFX) is a closed‐end interval fund providing interest income from a portfolio of loans to U.S. middle‐market companies. The companies are originated and managed by non‐bank lenders selected by Cliffwater LLC, an institutional alternatives firm with over $77 billion in assets under advisement. 

 

1. Stone Ridge Reinsurance Risk Premium Interval Fund (SRRIX) or the Stone Ridge High Yield Reinsurance Fund (SHRIX) attempts to deliver exposure to the reinsurance risk premium. 

 

1. AQR Style Premia Fund (QSPRX) which seeks to deliver value, momentum, carry and quality premiums across multiple asset classes. 

 

Note, a discussion of LENDX, CCLFX, SRRIX, SHRIX or QSPRX is provided for informational purposes only and is not intended to serve as specific investment or financial advice. This list of funds does not constitute a recommendation to purchase a single specific security, and it should not be assumed the securities referenced herein were or will prove to be profitable. Prior to making any investment, an investor should carefully consider the fund’s risks and investment objectives and evaluate all offering materials and other documents associated with the investment.

 

Cryptocurrency

While we caution against getting caught up in a cryptocurrency craze, it is possible that a small cryptocurrency allocation may offer diversification during inflationary times.  The theory is untested, but some have projected cryptocurrency could do well during high inflation. So, if you’re highly risk tolerant and comfortable speculating with a portion of your portfolio (to be clear: you could lose it all!), you may consider a position in Bitcoin (BTC) or a similar holding. 

 

Building Your Portfolio Out of Anti-Inflation Bricks

 

So, is big, bad inflation at our door? Time will tell. If it arrives, what should you do? To create your strongest defense, you must diversify. Diversify your equities, across risk factors and internationally. Diversify into and across your fixed income holdings. Consider additional diversification into alternative investments. Once you’ve created your globally diversified portfolio, sit tight with it when risks arise to huff and puff at what you’ve built. 

 

Inflation is an important consideration for many long-term investors. By combining the right mix of growth and risk management assets, investors may be able to blunt the effects of inflation and grow their wealth over time. Remember, however, that inflation is only one consideration among many that investors must contend with when building a portfolio for the future. 

 

We align our thinking with David Booth’s in the article mentioned above when it comes to risk: “I think part of planning is not only your investment portfolio, but what to do if you experience unexpected events of any kind.” This includes unexpected spikes of inflation.

 

Booth states, ‘“Control what you can control.” You can’t control markets. What you can do is prepare yourself for what you’ll do in case bad events happen. Inflation is just one of many risk factors long-term investors need to be prepared for.’

 

If you want to know more about how independent advice can help you defend against inflationary risks on the way to your financial goals, we hope you’ll sit down with our team today for a Cogent Conversation. 

 

We’ll listen to what success looks like for you, build a plan tailored to you, discuss options for you to limit the volatility in your portfolio and risk of loss of purchasing power, and help you execute that plan every step of the way. We will advise on how inflation risks can be mitigated within a portfolio, and also how best to protect your retirement savings to improve your overall plan.

 

[Additional, usual closing language?] 

 [WC1]I replaced the Feb. 2021 data and chart from the original piece with this more current data/chart. The Feb. 2021 date otherwise seemed rather arbitrary.

 [WC2]Provide link here, or if space permits, you may want to embed the video directly into the post.

 [WC3]Could listing two specific funds like this be a compliance concern? Recommendations out of context? If so, you could delete the examples.

 

 

 

 

 

 

 

 

Our Thinking on Inflation Risk: Is the Wolf at Your Door?

 

Who’s afraid of big, bad inflation? A lot of people are, and not entirely without reason. With the economy starting to recover from the COVID-19 pandemic, media outlets and investor concerns have been turning increasingly toward inflation risk. 

 

We all know the Federal Reserve (“the Fed”) has been injecting trillions of dollars of borrowed money into the economy. A national thirst for rebuilding infrastructure and digging out of COVID-19 is leaving our federal coffers—as well as many state and local balance sheets—with the biggest public-debt load as a percentage of gross domestic product (GDP) since World War II. Most other Western nations have been following suit. 

 

What could possibly go wrong? At least with respect to your investments, the answer is, inflation. If there’s enough geopolitical pressure to keep interest rates lower for longer, while debt continues to rise, the Fed may let inflation run higher than its stated, traditional 2% target. Maybe a lot higher. If inflation does take off, it could take a big bite out of your real rates of return.

 

Or not. 

 

So far, there have been no extreme inflationary risks realized. In its March 2021 “Long Term Budget Outlook,” the U.S. Congressional Budget Office found “no set tipping point at which a [debt-to-GDP] crisis becomes likely or imminent.” While we are in no way predicting all is well, neither is there evidence that it’s time to panic: 

 

• The strength of the U.S. dollar: This recent Wall Street Journal piece suggests a degree of confidence may be well placed, given a continued volume of “foreign investors who are happy to park their cash in the U.S.” 
• Global response: We’re also seeing evidence that other governments are trying to rein in their debt-to-GDP ratios. In November 2020, British finance minister Rishi Sunak described the U.K.’s public finance path as “unsustainable” over the long-term. 
• Economic analysis: As we’ll cover below, many economists are not yet crying “Wolf!” either over the threat of rising inflation. 

 

Let’s put these pieces together, and examine what it means to your evidence-based investment strategy. If you’d rather not read the entire explanation, our conclusion remains constant: As usual, we recommend ignoring fast-breaking economic forecasts, and focusing instead on maintaining a globally diversified portfolio based on your personal goals and risk tolerances. Admittedly, this isn’t the most entertaining advice in the world, but it beats guessing where your best financial interests are found.    

 

Much Ado About Inflation

 

“We haven’t been in a period of high inflation, or even moderate inflation, for at least 10 years,” says Gene Fama. Professor Fama and Dimensional’s David Booth discussed inflation recently. “I’m not particularly concerned that inflation will be high soon.” The exchange can be found HERE. 

 

One way to think about inflation is this: when the prices of goods and services increase over time, consumers can buy fewer of them with every dollar they have saved. This erosion of the real purchasing power of wealth is called inflation. Inflation is an important element of investing. In many cases, the reason for saving today is to support future spending. Therefore, keeping pace with inflation is a crucial goal for many investors.

 

Many economists like Merton Miller, PhD, believe market prices lay out the case for what the market expects. Miller has said, ““Everybody has some information. The function of the markets is to aggregate that information, evaluate it, and get it incorporated into prices.”1

 

The market does not seem to be bracing for wild inflationary extremes, despite the significant government spending and borrowing already underway. 

 

So, what is the market expecting? Let’s look to the markets and prices of certain securities for some insight. Often, consensus for future inflation can be measured by the 10-Year Breakeven Inflation Rate. This is the rate at which you’d receive the same total return whether you invested in Treasury Inflation-Protected Securities (TIPS) or Treasury bonds, while assuming average expected inflation for the next 10 years. 

 

In other words, the 10-Year Breakeven Inflation Rate represents the market’s best guess at what’s coming next. Although this makes the consensus a fuzzy forecast, it suggests the market was expecting an inflation rate of 2.46% as of June 1, 2021.[WC1]  A touch high, but not scary-high. 

 

 

Source: Federal Reserve Bank of St. Louis FRED Economic Data (https://fred.stlouisfed.org/series/T10YIE) 

 

Diversified Investing in Inflationary Times

 

Tempered by the preceding points, inflationary risks remain. The market is fickle, continuously processing and quickly reacting to the latest information. We like to speak in risks you can control and those you cannot.  

So, let’s say inflation remains, or even takes off in the months or years ahead. What’s an investor to do? 

 

First, remember what you CANNOT do: Unless you’re a member of the Federal Reserve, you cannot have an impact on inflation. In fact, even the Fed can only do so much. Instead, focus on what you CAN do. In a word, that’s diversification. Inflation and other risks routinely happen. So, building and maintaining a globally diversified investment portfolio remains your best “lever” to: 

 

(1) Protect what you’ve accumulated against the worst-case possibilities, while …

(2) Participate wherever and whenever the next best-case investment outcomes may strike. 

 

With that in mind, let’s review some of your best opportunities to diversify. 

 

Equity 

When it comes to diversification, step one is to buy and hold a well-diversified basket of equities. Over the long run, stocks should outpace inflation by far, to provide your best inflation hedge. This is especially the case if you diversify globally, and into the risk factors that are expected to yield higher returns (such as small-cap and value stocks). Consider the following:

 

1. Inflation: Thanks to a long-term average inflation rate of 2.97%, the goods and services you could purchase for $1 in 1926 would cost you more than $15 today.
2. U.S. stocks: What if you could have invested that same $1 in something like a U.S Large Capitalization Index back in 1926? Assuming reinvested dividends and an annualized return of just over 10%, your $1 at the end of 2020 would now be worth $10,937.
3. U.S. small-cap stocks: The same $1 diversified into U.S. small-cap stocks beginning in 1926 would now be worth more than $32,817.

 

As the value of a dollar declines over time, investing can help grow wealth and preserve purchasing power. Investors should know that over the long-haul stocks have historically outpaced inflation, but there have also been short-term stretches where this has not been the case. This makes a compelling argument for why equities should be included in a diversified portfolio to meet the goal of preserving long-term purchasing power for your assets. 

 

Note that past returns are not guaranteed and anyone who tells differently is lying to you. 

 

 

 

Fixed Income

In tandem with your diversified equity portfolio, your second course of action is to review your fixed income composition. 

 

When considering future consumption, one of the primary goals for investors may be the preservation of their purchasing power. Among many things, purchasing power can be affected by the real return of an investor’s fixed income portfolio. For instance, if the real return of the portfolio—the return the investor receives after inflation—is negative, purchasing power may be eroded, leaving a gap between the investor’s wealth and liabilities. Annual inflation in the US has been positive in 83 of the last 90 years and has not been negative since 1954.

 

Inflation erodes bond returns in general, and typically even more aggressively as bond maturity increases. For example, if a 30-year Treasury bond yields 4%, but inflation averages 6% annually during the same period, you lose 2% per year in real (net-of-inflation) terms across the entire 30 years. As this short Dimensional video[WC2]  explains, even short-term bonds can have exposure to inflation risk. Their returns have barely outpaced inflation historically, so they are an imperfect inflation hedge. Here are a couple of possibilities for addressing these issues: 

 

1. Ladder It: If you have a relatively large fixed income allocation (starting at $500,000 or more), you can own a ladder made of individual bonds to take advantage of higher rates as inflation rises. With a regular and steady flow of bonds maturing each year, you can reinvest into the higher rates to combat rising inflation.
2. Take on TIPS: Another option is to allocate a portion of your bond portfolio to short-term Treasury Inflation-Protected Securities known as TIPS. The short duration allows TIPS to respond to rising/falling inflation so, at least pre-tax, they are the only securities that are essentially guaranteed to outpace inflation. 

 

Note, however, investing in TIPS and other fixed income instruments can have tax ramifications, which we help our clients factor in as we devise a strategy that works best for their needs. 

 

Alternatives 

 

An investor may use alternative strategies for a modest portion of their overall allocation. Academic research has uncovered the benefits that some alternative strategies can add by either enhancing portfolio diversification or improving expected return. The alternative investment strategies we use in our and our client’s portfolios are held in mutual fund

form. We recommend modest allocations since these strategies have higher

expenses, are typically less tax efficient and the interval fund alternatives are not liquid.

 

There are many possibilities here, include alternative lending, reinsurance, and commodities and alternative lending investments. Commodities have tended to do well when inflation is higher than expected. Other funds may provide some inflation protection by holding very short-term notes, or offering a floating rate. 

 

Some example[WC3] s:

 

1. The Stone Ridge Alternative Lending Risk Premium Fund (LENDX) offers exposure to consumer and small business loans, which have historically been profitable for banks. 

 

1. The Cliffwater Corporate Lending Fund (CCLFX) is a closed‐end interval fund providing interest income from a portfolio of loans to U.S. middle‐market companies. The companies are originated and managed by non‐bank lenders selected by Cliffwater LLC, an institutional alternatives firm with over $77 billion in assets under advisement. 

 

1. Stone Ridge Reinsurance Risk Premium Interval Fund (SRRIX) or the Stone Ridge High Yield Reinsurance Fund (SHRIX) attempts to deliver exposure to the reinsurance risk premium. 

 

1. AQR Style Premia Fund (QSPRX) which seeks to deliver value, momentum, carry and quality premiums across multiple asset classes. 

 

Note, a discussion of LENDX, CCLFX, SRRIX, SHRIX or QSPRX is provided for informational purposes only and is not intended to serve as specific investment or financial advice. This list of funds does not constitute a recommendation to purchase a single specific security, and it should not be assumed the securities referenced herein were or will prove to be profitable. Prior to making any investment, an investor should carefully consider the fund’s risks and investment objectives and evaluate all offering materials and other documents associated with the investment.

 

Cryptocurrency

While we caution against getting caught up in a cryptocurrency craze, it is possible that a small cryptocurrency allocation may offer diversification during inflationary times.  The theory is untested, but some have projected cryptocurrency could do well during high inflation. So, if you’re highly risk tolerant and comfortable speculating with a portion of your portfolio (to be clear: you could lose it all!), you may consider a position in Bitcoin (BTC) or a similar holding. 

 

Building Your Portfolio Out of Anti-Inflation Bricks

 

So, is big, bad inflation at our door? Time will tell. If it arrives, what should you do? To create your strongest defense, you must diversify. Diversify your equities, across risk factors and internationally. Diversify into and across your fixed income holdings. Consider additional diversification into alternative investments. Once you’ve created your globally diversified portfolio, sit tight with it when risks arise to huff and puff at what you’ve built. 

 

Inflation is an important consideration for many long-term investors. By combining the right mix of growth and risk management assets, investors may be able to blunt the effects of inflation and grow their wealth over time. Remember, however, that inflation is only one consideration among many that investors must contend with when building a portfolio for the future. 

 

We align our thinking with David Booth’s in the article mentioned above when it comes to risk: “I think part of planning is not only your investment portfolio, but what to do if you experience unexpected events of any kind.” This includes unexpected spikes of inflation.

 

Booth states, ‘“Control what you can control.” You can’t control markets. What you can do is prepare yourself for what you’ll do in case bad events happen. Inflation is just one of many risk factors long-term investors need to be prepared for.’

 

If you want to know more about how independent advice can help you defend against inflationary risks on the way to your financial goals, we hope you’ll sit down with our team today for a Cogent Conversation. 

 

We’ll listen to what success looks like for you, build a plan tailored to you, discuss options for you to limit the volatility in your portfolio and risk of loss of purchasing power, and help you execute that plan every step of the way. We will advise on how inflation risks can be mitigated within a portfolio, and also how best to protect your retirement savings to improve your overall plan.

 

[Additional, usual closing language?] 

 [WC1]I replaced the Feb. 2021 data and chart from the original piece with this more current data/chart. The Feb. 2021 date otherwise seemed rather arbitrary.

 [WC2]Provide link here, or if space permits, you may want to embed the video directly into the post.

 [WC3]Could listing two specific funds like this be a compliance concern? Recommendations out of context? If so, you could delete the examples.