Inflation Investments: Defending Your Assets

Written by: Blaine Malcolm, CFP®, Wealth Manager, Partner

What word best describes the current state of inflation in America, as well as elsewhere around the world? From an investor’s perspective, “challenging” pretty much says it all. As of July this year, the latest ¾-point hike in the Federal funds rate acknowledged a level of inflation not seen in the U.S. in more than four decades. The aggressiveness of the hike solidifies the sense that we don’t have inflation under control. And it suggests we’ll see increased pressure in the months ahead.

A challenge that won’t disappear overnight

More than at any time in the last 15 years, people are paying close attention to the Consumer Price Index (CPI), which the U.S. Bureau of Labor Statistics defines as “a measure of the average change over time in the prices paid by urban consumers for a market basket of goods and services.” July figures released on August 10 showed an 8.5% year-over-year inflation rate, down from 9.1%. This certainly is welcome news. And although a few even believe a miraculous drop to 2.5 percent overnight is possible, a continued gentle reversal really would be enough to indicate the direction of inflation is subsiding. Is such a disinflationary trend beginning? The next few months may bring some relief, although it might be well into 2023 before a sustained decrease in the inflation rate is established.

While the best investments in any given inflationary period depend to some extent on myriad business, economic and geopolitical factors that nobody can predict with certainty, some general observations are valid. With that in mind, let’s look at a few things to consider when deciding what to invest in during inflation.

The safest investments for inflation

In the fixed-income segment, cash offers ultimate protection of nominal value as interest rates rise, but at the cost of a steady erosion of real value, since its low interest rate won’t keep pace with inflation. This means cash is best reserved for very short-term liquidity needs or as “dry powder” for near-term purchases of other assets. To earn a bit more while still minimizing the downward pressure bond prices experience as the Fed raises interest rates to battle inflation, consider very short-term U.S. Treasury instruments with durations under a year, as well as ultra-short mutual bond mutual funds or ETFs. Internationally, China is one of the only nations cutting rates at the moment, offering some potential for fixed-income investors along with its own distinctive risks.

Of course the U.S. securities specifically designed for inflation protection also deserve consideration—with caveats for each. TIPS (Treasury Inflation-Protected Securities) shine during periods such as the present one. There’s not a better time to add them. If you do, though, consider this a short-term plan, and be prepared to revisit your position when the inflation rate has stabilized and become more predictable. Right now Series I Savings Bonds (I Bonds) also provide a very attractive combination of a fixed rate of return throughout the 30-year life of the bond, plus a variable inflation rate that’s calculated twice a year. The downside is a $10,000 maximum purchase per household member per year, as well as a three-month interest penalty if a bond is cashed in before you’ve held it for at least five years.

As far as equities go, dividend plays historically have done relatively well compared to other stocks during inflationary periods. So far, this year has been no exception. High-performing companies with strong balance sheets, acquired at attractive prices, can generate a dividend stream that supports cash flow when rotating out of fixed-income assets. You can acquire these stocks individually, or through a Dividend Aristocrats ETF or fund that holds firms with a proven track record of raising their dividends annually. Since international equities tend to experience the same headwinds and follow the same path as U.S. stocks, we also believe overweighting domestic equities compared to international currently is a prudent move.

Investments to avoid during inflation

While the impact of inflation on various sectors of the equity and bond markets can be negative in different degrees, there’s one category of asset that truly has “Beware” written all over it during a period of rising interest rates. Long-term bonds, specifically durations of ten years or more, can suffer dramatic declines in principal. A Fed funds rate rise of just several points can send these longer-duration bonds, and of course any ETFs or funds that hold them, into a bear market that rivals a major equity selloff. Holding debt with intermediate and shorter durations—about five years or less—entails substantially less interest rate risk. If held as individual bonds, this includes a more rapid restoration of principal to par value due to the shorter time until maturity. Without high confidence in the near-term direction of inflation, and how much further interest rates may rise to combat it, avoiding new investments in long-duration bonds is highly recommended at the present time. Whether it makes sense to rotate out of any you already own and perhaps harvest a capital loss is a question to discuss with a financial advisor who is familiar with your specific portfolio and goals.

Alternative strategies

In inflationary times, the appeal of strategies outside the usual stock and bond asset classes often increases. Such strategies include managed futures, whose portfolios of professionally managed long and short futures contracts tend to be inversely correlated with stocks and bonds. While managed futures may prove successful as a risk-reduction strategy for some investors, there are many different programs and proprietary trading methodologies to choose from. Considering the evaluation effort required to ensure a given program matches your investment objectives and risk tolerance, we would hesitate to characterize the strategy as “safe” for every investor looking to diversify for inflation protection.

Another strategy that often attracts attention during inflationary times like these is absolute return. A conventional fund or ETF seeks relative returns that are better than a specified benchmark or market segment—which means if they lose less money than the benchmark in a given down period, they’ve still succeeded. Absolute return strategies, on the other hand, employ a variety of techniques in pursuit of a positive return under all market conditions. Depending on the strategy, anything from stocks, bonds and currencies to options, derivatives, arbitrage, and unconventional assets might be in the mix; it may also be a “fund of funds” constructed from diverse ETFs or mutual funds. While not expected to beat the market during rallies, absolute return strategies are intended to deliver a more predictable sequence of returns and lower volatility over time than strategies with a more constrained selection of assets or less risk-focused trading methodology.

Nobody can guarantee what the CPI or interest rates will look like in the months and years ahead. But meeting with your financial advisor to discuss your own situation and goals can help determine whether your portfolio might benefit from updating to incorporate the best investments for inflation.

Whether you’re looking for specific guidance or investment advice to help you navigate today’s challenging economic environment, or you’re ready to begin planning the financial journey that will help you achieve your goals, reach out to one of our advisors to discuss how they can help. Contact Merit Financial Advisors today!

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

Alternative investments may not be suitable for all investors and should be considered as an investment for the risk capital portion of the investor’s portfolio. The strategies employed in the management of alternative investments may accelerate the velocity of potential losses.

All investing involves risk including loss of principal. No strategy assures success or protects against loss.