As we embark on four years of Donald Trump in the Oval Office, no one knows if Trump’s policies, which center on lower taxes, deregulation, and expansionary fiscal policy, are simply political rhetoric or if they are serious proposals that a Republican majority in Congress will craft into legislation. And that uncertainty has investors around the globe perplexed.
Trump’s policies combined with stabilizing commodity prices and low unemployment have the potential to increase economic growth along with inflation, while a tighter Fed policy and stronger U.S. dollar could keep inflation contained. The consensus among economists is that inflation will increase to north of two percent in 2017, which would mark the first time since prior to the Credit Crisis that we’ve experienced consecutive years of inflation above two percent.
Below we examine how financial professionals can use different asset classes to help position client portfolios to guard against inflation as well as contribute to total returns. We also list some of the top performing strategies from the PSN Global Manager Neighborhood database for each asset class during years of inflation over two percent.
Inflation risk is typically associated with fixed income products since inflation reduces the purchasing power of fixed interest payments the investor receives. Additionally, the Fed typically increases rates during times of rising inflation to cool the economy, which decreases the prices of fixed income products.
Fortunately, fixed income investors have choices to help hedge against inflation risk.
Treasury Inflation-Protected Securities (TIPS)
The most popular option are Treasury Inflation-Protected Securities (TIPS), which help protect against unexpected inflation because their interest payments reflect the stated fixed interest plus the inflation amount as measured by the Consumer Price Index (CPI). Additionally, the bonds principal also adjusts as the CPI changes. Figure 1 shows how TIPS perform during inflationary periods.
Figure 1 - Source: Bureau of Labor Statistics, Zephyr StyleADVISOR
Floating Rate Bonds
As we mentioned prior, rising interest rates often coincide with inflation, making floating rate bonds a good option to hedge inflation and interest rate risk, as their interest payments adjust to changes in key interest rates. Conversely, medium and longer-term bonds typically underperform due to the rising interest rates and erosion of the fixed interest payments. Figure 2 shows how floating rate strategies perform during periods of inflation over two percent.
Figure 2- Source: Bureau of Labor Statistics, Zephyr StyleADVISOR
High Yield and Emerging Market Debt
Today’s low yield environment causes additional concerns as financial advisors must search for higher yielding investments to meet income requirements. Depending on the investors risk tolerance, this additional yield may be found in high yield and emerging market debt. The commodity rich emerging market economies fare well during inflationary periods as the prices of commodities tend to increase. Figure 3 shows how high yield strategies hold up during inflationary periods and figure 4 shows emerging market debt strategies.
Figure 3 - Source: Bureau of Labor Statistics, Zephyr StyleADVISOR
Figure 4 - Source: Bureau of Labor Statistics, Zephyr StyleADVISOR
If inflation has you really concerned, convertible bonds provide investors with a product that has bond-like features with the bonus to capitalize on the potential increase in the common shares price. Figure 5 shows some of the top performing convertible strategies found within the PSN database.
Figure 5 - Source: Bureau of Labor Statistics, Zephyr StyleADVISOR
Equities, unlike fixed income tend to perform well relative to inflation over the very long term as company’s can offset their rising costs by increasing the price of their products. During these periods, company earnings may benefit with a growing economy, low unemployment, and increasing consumer spending. Conversely, equities can come under pressure during the short term and/or periods of unexpected inflation, as uncertainty around the economy and company’s earnings forecasts hinder their performance.
Interest rate hikes, which tend to coincide with inflation, benefit banks, as the spread widens between the amount banks charge on loans versus the amount of interest they pay out on customer savings. Obviously, financials didn’t fare so well during the credit crisis, although during the other periods, financials performed well, as you can see in figure 6.
Figure 6 - Source: Bureau of Labor Statistics, Zephyr StyleADVISOR
Real Estate (REITS)
Real estate companies have the potential to fare well since they can pass their rising costs on to their consumers in the form of increasing rents and/or higher construction costs. As figure 7 shows, outside of the credit crisis, real estate strategies performed very well during these inflationary periods.
Figure 7 - Source: Bureau of Labor Statistics, Zephyr StyleADVISOR
Commodities, Natural Resources, and Energy
Finally, commodities, which often are a cause of inflation, are also a common hedge. Food and energy make up 25% of the CPI bucket, so commodities such as wheat and oil have a higher correlation to inflation. Due to this high correlation to the CPI, commodities tend to experience the largest price appreciation. Commodities are also priced in U.S. Dollars, which poses as an opportunity as well as a risk.
Figure 8 - Source: Bureau of Labor Statistics, Zephyr StyleADVISOR
Just like every investment is unique, inflationary periods are built differently as well. As we enter this uncertain period it is very important to be aware of the risks as well as the opportunities that these investments hold as you build a diversified portfolio for your clients that can provide reduced risk as well as a real return that helps achieve financial goals.