What Should I do with my investment portfolio during inflation?

Is inflation on your mind?  We would be surprised if it weren’t.  While we all have to weather inflation’s short-term effects, we have reason for optimism over the long term.  Here’s a look at where we are right now.

What is causing inflation?

The effects of nearly two years of the pandemic compounded by the Omicron variant’s impact hamper economic recovery as we face labor shortages, supply chain disruptions, and inflation.

Recent inflation has been attributed to shortages caused by the supply chain issues and increased demand as the economy reopened, and the war in Ukraine impacts supply chains, but if the tight labor market continues to bring higher wages, there may be longer-term implications

What does higher inflation mean to our financial lives?

Housing, transportation, and food costs are the largest components of inflation for consumers, but the changes in work brought on by the pandemic may give consumers more ways to stem inflation’s effects.

Many who are typically most affected by inflation, including service employees and other lower-to-mid level workers, now have more options. We are already seeing major shifts in housing as those who have some work flexibility move from higher cost areas to lower cost ones to maintain or enhance their quality of life.

Why does monetary policy matter when it comes to inflation?

Historically, periods of major government monetary policy stimulus, such as lowering interest rates, led to increases in inflation.

The last decade has seen the longest and lowest period of interest rates ever, near-0% for a decade, plus other major stimulus programs designed to respond to the global financial crisis and the pandemic.

During COVID, for example, Congress enacted a series of relief bills, three of which provided for direct payments to American households.The CARES Act, the Consolidated Appropriations Act, and the American Rescue Plan have served as support for the unemployed, small businesses, state and local governments, schools and more.

This government injection of cash into our battered pandemic economy and into the wallets of workers has been historic and creative, and almost certainly prevented the economy from a much worse fate, but is now probably a contributing factor in rising inflation rates.

In response to rising inflation, the Federal Reserve has been raising interest rates, making lending (and borrowing) more expensive, in the hopes of slowing down demand and inflation.

How does inflation affect the stock market?

Higher rates increase the cost of borrowing, which reduces the disposable income of consumers and the profitability of companies, and puts downward pressure on stock prices.

However, if wages don’t rise enough across middle and lower-income households, disposable income diminishes and spending is weak. This can cause company profitability and reasonable price rises to be weaker, which can also put downward pressure on stock prices, especially given that about 70% of GDP comes from consumer spending.

Finding the right balance of employment, rates, and economic equality is not easy, but can create a more stable economy and less extreme stock price swings.

Can rising rates help?

For those that are approaching or in retirement, rising rates can actually be helpful. Those that are gradually reducing their stock market exposure and increasing bonds will experience higher average bond returns over the long run. There may be some bond volatility along the way, and it is the after-inflation return that matters most, but the effect can be beneficial as higher-yielding bonds are added to the portfolio.

Staying invested helps outpace inflation over the long run

For investors, equity markets have proved to be a strong hedge against inflation over time. Most recently, during the 30 years from 1991 through June 2021, the S&P 500 posted an average annualized return of 8.5% after adjusting for inflation. Going back to 1926, the annualized inflation-adjusted return on stocks has been 7.3%.[1] While there will always be short-term disruptions and periods of negative returns, history shows that stock market returns tend to outpace inflation.

If your portfolio is already well-designed and globally diversified into an allocation of stocks and bonds appropriate for your risk profile, time horizon and financial goals, then no portfolio adjustments may be necessary.

However, if you have an all-passive portfolio, including all-indexed bonds, you may have hidden risks. Indexed bond portfolios have higher “duration” or interest rate risk than most actively managed bond portfolios and often have less overall bond diversification, and often don’t have dedicated short-term bond components or other key bond asset classes for diversification. That higher interest rate risk increases your bond downside risk during a rising interest rate environment.

Rising prices do not necessarily make it harder to reach your goals. For those who may be particularly sensitive to unexpected inflation, inflation-sensitive asset classes and inflation-indexed bonds can offer protection.

If you are uncertain about your asset allocation or if your time horizon or risk profile has changed, now would be a good time to review your investment plan.

Resilience and innovation

It’s likely that the pandemic will yield enduring changes to how we live and work. We, as a society, are proving our resilience. At The Advisory Group, we are confident that markets will prove their resilience, too. Over time, financial markets find new opportunities and innovate. These last two years would certainly not be the “opportunity” we would choose; but, as always, we adapt and move forward.

Now might be a good time to check in on your financial plan or get one started, especially if you’re feeling unsettled or have new financial goals.  Request a consultation with one of our CFP® professionals and take the next step in securing your financial future.

[1] Dimensional Fund Advisors, September 17, 2021