As the COVID-19 pandemic begins to recede in the U.S. and the economy reopens, shortages of goods and high government spending have inflation on the rise.  Gradual price increases over time are a good indicator our economy is growing again.

The most recent reading of the Consumer Price Index (CPI) resulted in a gain of 5.0%, the highest registered increase since 2008.  After more than a decade of inflation running too cold (less than 2% a year), worry is mounting that the rate will jump to unhealthy levels as consumer and business spending activity picks up the pace this year.

Inflation and taxes are two critical elements to investing. Unfortunately, both can erode investment returns over time. But, unlike with taxes, inflation is the invisible roadblock we might not always be able to see.  Even small increases in inflation can wreak havoc on long-term investment assets, so having a sound investment mix may help moderate the impact.

I hope to offer some perspective on how investors should think about inflation in the context of their investment portfolios.  But before I discuss the investing aspect, it is essential to understand inflation and its effects.

How Inflation Impacts Investors

When the prices of goods and services increase over time, money doesn’t go as far.  For example, a gallon of milk cost $2.16 in 1980. Today, it costs roughly $3.52. This erosion of the real purchasing power of wealth is known as inflation.

In many cases, the reason for investing today is to support future spending.  At Bloom Advisors, we have always counseled clients that they need a rising income in retirement to keep pace with the cost of living.  Consequently, keeping pace with inflation is a worthy goal for many investors saving for retirement.

As the value of a dollar declines over time, investing can help grow wealth and preserve purchasing power.  This loss of purchasing power is a well-known concern among investors, and the Federal Reserve works to monitor and control inflation.  Investors always wonder, how will the Federal Reserve respond to higher inflation?  Will they raise interest rates more than expected to fight back inflation?

An abrupt change in the Federal Reserve’s monetary strategy to fight inflation would negatively impact most asset classes, including stocks and bonds. Moreover, it would mean raising short-term interest rates at a time when our economy remains fragile.  I’m not suggesting inflation will rise to the levels we saw in the mid-1970s and early 1980s, but if inflation starts to go much above 4-5% for an extended period, the Fed may need to act.

Asset Classes to Consider

In its quest to be helpful, the financial media often generates more fear than is necessary when it comes to inflation.  I’ve heard advice including, “bonds are bad because they can’t keep up with inflationary pressures” to “pricey growth stocks are susceptible to rising interest rates”.  In my opinion, the answer may lay somewhere in between.

Here are viewpoints on some asset classes investors should consider as they contemplate adjusting their investment portfolios for higher inflation.

Stocks

Investors should know that stocks have historically outpaced inflation over the long haul, but there have been short-term stretches where this has not been the case.  For example, during the 17 years from 1966-1982, the return of the S&P 500 Index was 6.8% before inflation, but after adjusting for inflation, it was 0%.  Furthermore, if we look at the period from 2000-2009, the so-called “lost decade,” the S&P 500 Index return dropped from -0.9% before inflation to -3.4% after inflation. In this way, despite inflation challenges, some stock market sectors like financials, natural resources/energy, and industrials, may benefit from inflation pressures.

Foreign stocks may also benefit from inflation pressures since lower to negative real interest rates could weaken the U.S. dollar, making emerging markets stocks and other developed areas more attractive as possible inflation-beating asset classes.

Bonds

Typically, investors buy fixed-income securities such as bonds, Treasuries, and CDs because they want a stable income or protect their portfolios from stock market volatility.  All bonds pay a fixed stream of interest payments whether one owns individual bonds or bonds in mutual funds.  Since the interest rate stays the same, the purchasing power of the interest payments decline as inflation rises.  As a result, bond prices tend to fall when inflation is increasing.

However, some bonds like floating rate, high yield corporates, emerging markets, and even certain mortgage bonds may hold up better since they generally have higher yields than safer securities like Treasury bonds and CDs.  It is crucial to have a diversified mix of bonds in this environment as I expect interest rates to go higher in the years ahead.

Other Assets

Real assets, such as commodities and real estate, tend to have a positive relationship with inflation. For example, energy-related commodities like oil have a strong relationship with inflation.  Real estate may be helpful, but not all areas of commercial real estate work well against inflation.  Unfortunately, these sectors tend to be highly volatile, so if inflation does not materialize, they may not be effective inflation defenders.

Bottom Line

Inflation can have a significant impact on your portfolio over time.  We know there have been periods when inflation has outperformed stocks and bonds, but inflation has been less harmful to overall performance over the long term.  It may also be possible the recent spike in inflation is only temporary.

Diversifying your portfolio with exposure to U.S. and foreign stocks and certain types of bonds may help defend your money against inflation. In addition, using real assets like commodities and other energy-related areas may help guard against higher inflation, but know they come with higher risks.

Inflation might be beyond our control for a certain point, but that doesn’t mean you can’t take action to help preserve your investments from its effects.