Talking hedges: Inflation perks up

A perspective from E*TRADE Securities 06/10/21

After a decade of persistently low inflation, prices across the board appear to be on the rise.

Measures of inflation, including the Consumer Price Index (CPI) and the Federal Reserve’s preferred Personal Consumption Expenditures Price Index (PCE), have risen sharply since April. The Producer Price Index (PPI), which measures prices from the seller’s end, has increased as well. 

Commodity indexes are near their highest levels of the past half-dozen years, with some markets posting record-breaking rallies over the past few months. Several companies, including Procter & Gamble, General Mills, and Kimberly Clark, have said they are raising the prices of their products as a result of higher commodity costs.

Some market watchers, as well as the Fed, believe the jump in prices is likely transitory—the product of a recovering economy coming off extremely low base levels and grappling with supply bottlenecks. However, others, including Morgan Stanley, argue that the post-pandemic business cycle has ushered in a new period of sustained, higher inflation, driven by global economic shifts.  

Either way, the inflation debate has been front and center in market headlines lately, and some investors are likely curious about different strategies and asset classes that may help combat the risk of inflation to portfolios. We break it down below.

Source: US Bureau of Labor Statistics (BLS)


Stocks

Long term, returns on stocks have tended to keep pace with, or stay a little ahead of, inflation. Many companies can pass higher prices on to consumers, which may help preserve (or even potentially improve) margins and profits. Take, for example, essential consumer products—prices may rise, but people will still purchase food and medicine.

Price growth may also boost the stocks of financial, energy, and materials companies, particularly amid periods of higher interest rates and commodity prices. 

On the other hand, rate-sensitive sectors such as utilities, which may have a harder time raising prices because of regulations—could be negatively affected. 

Treasury inflation-protected securities

Another asset that can offer some defense are bonds indexed to inflation. Treasury inflation-protected securities (TIPS) are pegged to the CPI. When the index rises, so does the investment in TIPS. And it’s not just the base value that increases. The interest payment, or coupon, which is based on the principal value, increases too. Of course, the opposite is also true. If the CPI falls, so does the value of the TIPS principal and its coupon.

Source: Bloomberg, Morgan Stanley Wealth Management Market Research & Strategy


One consideration, however, is that with rates still near historical lows, the return on the original investment may be muted. 

Commodities

Commodities—the raw inputs for many industries—may also provide a way to keep pace with inflation. Although prices of everything from steel and copper to lumber and corn have skyrocketed over the past year or so, some investors may seek exposure to commodity-based companies or commodity-focused mutual funds or exchange-traded funds (ETFs). 

Of course, one of the oldest inflation hedges is gold. Despite its popular reputation, however, the yellow metal does not have a track record of protecting against long-term, sustained inflation—although it may be a better store of value than the dollar. 

Real estate investment trusts

Finally, real estate may function as an inflation hedge, whether through physical ownership or investing. Rental income often increases over time to keep pace with rising prices.

But because physical real estate can be complicated and is a less-liquid market, some investors may explore real estate investment trusts (REITs). As inflation drives rent prices higher, there is the potential for more cash flow to be passed along to shareholders via dividends and buybacks. 

Rising interest rates can be a headwind for REITs, but an accelerating economy may be able to mitigate that rate risk for certain REITs, so it’s always important to do some homework. 

Bottom line, there’s no such thing as a perfect inflation hedge, but diversifying portfolios with a mix of assets may be important if higher prices prove to be more than just a passing risk. At the very least, investors may want to revisit individual goals, timelines, and risk tolerance and make sure portfolios are aligned.

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