Protect Against Inflation

Protect Against Inflation

Inflation has been a growing topic of concern for most investors in recent months. The latest inflation figures are well above central bank targets in both the U.S. and Canada.

Elevated inflation levels are occurring due to a variety of factors including higher energy prices, ongoing supply chain issues and pent-up demand being unleashed as prices recover from subdued levels reached earlier in the pandemic. It’s believed that these pressures will eventually ease over time, but this may result in inflation being more persistent than originally expected.

Many central banks have begun striking a more hawkish tone recently by announcing the end of quantitative easing and hinting that rate hikes are likely to begin sooner, and possibly with increased frequency, than previously anticipated.

Consumer Price Index (Year over Year)

consumer price index (year over year)

Source: Bloomberg, as at January 31, 2022. One cannot invest directly in an index. 

Consumers have been experiencing the impact of rising prices in their daily lives with significant increases in the cost of everyday essentials such as food and fuel. This also poses the question as to how investors can position their portfolios to mitigate the impact an inflationary environment can have on different asset classes such as fixed income and equities.

 

Positioning Fixed Income to Protect Against Inflation

Bonds are generally added to a portfolio to lower overall volatility and mitigate downside risk. Elevated inflation pressures tend to increase the risk of rising rates. In environments where interest rates are on the rise, prices of traditional, longer-dated bonds can be negatively impacted which can result in more volatile bond returns and as a result diminish some of these intended portfolio benefits. There are certain tools and considerations that can help investors manage these risks.

Diversification is key and investors with traditional long duration exposure comprising the bulk of their bond portfolios can face increased challenges during a period of rising rates. Fixed income securities can differ quite substantially when it comes to interest rate sensitivity. For one, shorter duration bonds limit risk as their prices are less vulnerable to interest rate changes. In addition, portfolios with exposure to Treasury Inflation Protected Securities (TIPS) and Real Return Bonds* can help to alleviate some of the risk as the principal of these securities increases in-line with the rate of inflation. Finally, other fixed income asset classes such as floating rate loans, convertible bonds and high yield debt have also historically performed well during these periods. Looking at the table below, we can see how these fixed income asset classes have exhibited a positive correlation with inflation and therefore could potentially offer stronger inflation protection than traditional longer-dated bonds.

Fixed Income Correlations with Inflation

Fixed Income Correlations with Inflation

Source: Morningstar Direct. Period: January 2002 – January 2022. In U.S. Dollars. S&P/LSTA Leveraged Loans Index (Bank Loans, Bloomberg US Corporate HY Bond Index (HY Bonds), ICE BofA US Convertibles Index (Convertible Bonds), Bloomberg US Treasury TIPS Index (TIPS), Bloomberg US IG Corporate Index (Investment Grade Corporates), Bloomberg US Treasury 10+ Year Index (10+ Year Treasuries), Bloomberg US Treasury 10-20 Year Index (10-20 Year Treasuries), Bloomberg US Treasury 20+ Year Index (20+ Year Treasuries), Ibbotson Associates SBBI US Inflation Index (Inflation). For illustrative purposes only. One cannot invest directly in an index.

Positioning Equities to Protect Against Inflation

Equities in general have historically performed well and delivered positive real returns during inflationary periods however, some equities may be better poised to outperform during these periods. The ability to manage input costs, while simultaneously passing price increases on to consumers, can vary by company and sector.

Companies in the energy and materials sectors can benefit from rising input prices such as oil and gold. Infrastructure and real estate companies are generally able to pass on rising costs to end users as well as benefit from higher revenues. In addition, companies with lower valuations and high current cashflows may present an intriguing opportunity as higher interest rates will erode the present value assigned to future cashflows for growth companies.

Like fixed income, equity positioning can include the addition of strategies that target specific themes to hedge inflation. Positioning can also include more comprehensive strategies with dynamic portfolio construction to navigate changing market conditions.

Average Cumulative Returns During Inflationary Periods (CPI > 2.5%)
average-cumulative-returns
Average Annualized Returns Since 2004
Including All Periods
Average Annualized Returns

 

Source: Morningstar Direct as at 02/17/2022. Inflationary periods include the following timeframes since 2004 when YOY CPI was 2.5% or greater for more than a quarter: 06/01/2004 – 09/01/2006, 04/01/2007 – 07/01/2007, 10/01/2007 – 11/01/2008, 04/01/2011 – 04/01/2012, 05/10/2018 – 09/13/2018 and 04/13/2021 – 01/31/2022. US Equities are represented by the S&P 500 Index, US Bonds by the Bloomberg US Aggregate Bond Index, Real Estate by the Morningstar US Real Estate Index, Infrastructure by the Dow Jones Brookfield Americas Infrastructure Index and Energy by the Morningstar US Energy Capped Index. In $USD. One cannot invest directly in an index.

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