Preparing for Higher Inflation: What Investors Need to Know

THE “I-WORD,” INFLATION, has recently leapt back into the national conversation, after years when it barely registered as a concern. June’s Consumer Price Index (CPI) numbers showed prices increasing 0.6% in May over the previous month and 5% over the previous year—the biggest 12-month gain since August 2008.¹ While these results don’t guarantee a long-term trend, "both market and consumer-based measures of inflation expectations have been trending higher since early last year," says Jonathan Kozy, senior macro strategy analyst, Chief Investment Office (CIO), Merrill and Bank of America Private Bank. Among the primary inflation catalysts, he cites money flowing into the economy from massive pandemic stimulus, an ongoing economic recovery, short-term supply constraints and a sharp rise in consumer savings and confidence.

For the past decade, inflation has averaged well below the 2% target rate set by the Federal Reserve (the Fed) and has been generally declining since 1980. Nevertheless, for some, rising prices may evoke uncomfortable memories of the double-digit inflation of the 1970s, notes Kozy, co-author of a recent CIO report, “Inflation ABCs and Portfolio Strategy.”  Yet while that level of inflation can be harmful, an extended period of moderate inflation (at or slightly above 2%) could be a welcome sign of economic strength, says Joe Curtin, head of Portfolio Management for the Chief Investment Office, Merrill and Bank of America Private Bank. In fact, since the financial crisis of 2008 and 2009, “central banks have been trying to reflate global economies,” he adds. Here, Curtin and Kozy discuss the role of inflation in the economy, what to expect from rising inflation and how investors can prepare.

What is inflation and how is it measured and controlled?

Unlike a sudden increase in the price of a specific product or service, “inflation refers to a broad increase in goods and services prices in the economy over time,” Kozy says. A variety of indexes, including the Bureau of Labor Statistics’ CPI, track rising and falling prices. The Federal Reserve, which is charged with controlling inflation, uses the personal consumer expenditures (PCE) index, which measures prices across a broad range of consumer spending.

The Fed’s main tool for managing inflation is to raise or lower interest rates. When the economy struggles and inflation stays below the 2% target the Fed considers healthy, it reduces rates to spur economic growth and employment. When the economy heats up, raising rates can help slow the economy and keep inflation from getting out of hand. Yet with inflation averaging just well below the 2.0% target in the decade leading to the pandemic, and to avoid disrupting the recovery, the Fed has said it will keep rates low and allow inflation and inflation expectations to rise and remain above 2% as long as necessary to bring the long-term average back to target levels, Kozy notes.

What’s the impact of inflation on consumers and investors?

During rising inflation, consumers face higher prices on goods and services, and this can be particularly challenging for retirees living on fixed incomes, as their buying power diminishes. As low interest rates persist, income from traditionally “safe” investments such as bonds and cash may not keep pace with rising prices. At the same time, it’s important to note that “moderate inflation is a sign of a healthy economy, where consumers are spending and businesses are prospering,” Curtin says. Many investors have benefited from strong stock market performance in recent years, and they may potentially continue to do so as the economy rebounds from the pandemic. “Retirees and other investors may find that a diversified portfolio generates returns that can beat inflation,” he adds.

What can equity investors consider doing now?

"Higher inflation boosts nominal economic growth, which may, in turn, help boost earnings and ultimately stocks,” says Kozy. Going back to 1961, during times when inflation has run between 1.5% and 2.5%, returns for S&P 500 stocks have averaged more than 15% during the following year, according to the Chief Investment Office. By contrast, lower inflation of .5% to 1.5% produced returns averaging less than 7%.²

Now may be a good time for investors to review their stock portfolios, Curtin advises. The economic downturn of 2020 initially favored companies in technology-related industries with digitally-enabled business models, in addition to other segments that saw a pandemic-induced spike in demand. With inflation and growth expectations on the rise through recovery, investors may now want to consider adding stocks with more exposure to cyclical pockets of the economy, such as small-cap or value funds—companies that may be currently undervalued or have higher potential to grow profits. “We are in the early stages of a multiyear market and economic cycle,” Curtin says. “At the beginning of a market cycle, your chances of beating inflation and getting a real return may be strongest with higher-risk assets.” Yet any investments should be made according to your overall goals, time horizon, liquidity needs and how you feel about risks, and as part of a balanced portfolio, he adds.

How could bonds be affected by inflation?

With the Federal Reserve keeping interest rates low, bond income may be especially vulnerable to inflation. To help counter its effects, investors may want to consider Treasury Inflation-Protected Securities (TIPS), which are indexed to rise in value as inflation rises. In a couple of years, if the economy continues to grow, the Fed may be less worried about stalling the recovery, and more concerned about keeping a lid on inflation, Curtin says. In that case, higher interest rates could once again make bonds (or even cash) an attractive source of returns.

Are there other options investors can consider?

Real estate and real assets such as farmland or timberland have historically risen in value along with inflation, Kozy says. Another option to consider, depending upon your risk tolerance, is commodities—raw materials such as metals, energy or agricultural products. Yet keep in mind that commodities are subject to market volatility. Because few investors are prepared to take delivery of, say, a barrel of oil, most tend to invest in commodities by purchasing stocks of companies that produce commodities, or through funds that invest in commodities futures. These funds typically hold a fair amount of cash, and with interest rates low, those cash holdings may dilute some of the returns, Curtin says.

The risk of overreacting

As the inflation picture evolves in the months to come, clients should keep an eye on inflation and speak regularly with their advisors about portfolio changes that could help them stay prepared, Curtin says. “A diversified approach is best. That means determining what’s necessary to meet your goals over the long-term and making adjustments incrementally.”

The most important advice may be to avoid overreacting or letting inflation fears dominate your concerns. A period of 1970s-style runaway inflation could indeed damage consumers, investors and the economy. “But we’re so far away from anything like that,” Curtin says, “we should be celebrating the fact that the economy is doing pretty well.”