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Inflation Station!

Updated: Jan 3, 2024



The Federal Reserve has embarked on a robust journey of interest-rate hikes, wielding its power to keep inflation in check—for the time being. However, let's ponder the what-ifs. What if the factors that ignited last year's inflationary blaze, driving consumer prices to their loftiest peaks in decades, decide to linger around longer than anticipated?

It's crucial to bear in mind that despite the comforting pattern of declining inflationary pressures in the United States over the past four decades, the pendulum can indeed swing in the opposite direction. In fact, indicators are signaling that the U.S. finds itself in the midst of an era marked by an accelerating structural inflation—something not witnessed for decades. And it's conceivable that this trend may persist into the foreseeable future.

Such a scenario could carry substantial implications for investors. Until 2022, an entire generation of investors had grown accustomed to certain assumptions about how various asset classes behave in the context of market volatility, all under the umbrella of a low-inflation environment. But if the recent surge in inflationary pressures proves enduring, these long-standing assumptions may crumble, prompting investors to reevaluate their portfolio strategies accordingly.

Investing Amidst the Inflationary Current

Holding steadfast to the belief in "more of the same" could lead investors astray, causing them to misjudge the risk, return, and diversification potential inherent in their portfolios. As we navigate the potential resurgence of structural inflationary pressures, our strategists recommend reevaluating the allocations within portfolios, particularly with regard to interest-rate-sensitive equities, such as large U.S. growth stocks—a shift that may not have been prudent in previous market environments.

Two fundamental shifts in the behavior of asset classes may come to the forefront in a persistent-inflation environment.

Firstly, asset classes traditionally perceived as "lower risk" may offer diminished stability and less diversification potential during periods of inflation. For instance, bonds have long been valued for their lower volatility compared to stocks, but as evidenced in 2022, fixed income can exhibit significant volatility and align more closely with equities when inflation is on the ascent. Should this trend persist, investors may need to rethink popular investment strategies like the classic 60/40 portfolio, which hinge on assumptions of low fixed-income volatility and stable correlations between bonds and equities.

Secondly, prolonged inflation may render specific asset classes more appealing. Consider the following:

  • International equities may present heightened diversification potential and could outperform U.S. growth stocks on a risk-adjusted basis. Prior to 2022, U.S. growth stocks dominated benchmark indices for an extended period.

  • Real assets, such as commodities and publicly traded real estate, could offer superior diversification prospects amid elevated inflation. Commodities often flourish in inflationary environments due to rising prices. Similarly, real estate investment trusts (REITs) may thrive when inflation and interest rates are elevated, especially in stagflationary scenarios.

  • Cash may assume a more substantial role in portfolio diversification as inflation escalates. During the extended bond bull market, many investors sought to minimize their cash holdings, as it failed to deliver attractive risk-adjusted returns compared to fixed income. However, recent months have seen cash equivalents, like Treasury bills and high-yield savings accounts, provide higher yields than longer-term U.S. government bonds, all while avoiding the turbulent interest rate swings that have inflicted losses on fixed income portfolios.

As for whether the future holds a sustained era of elevated inflation or a rapid return to historically low levels remains uncertain. What is unequivocal, however, is that adapting to the prospect of a new economic landscape sooner rather than later could position investors favorably for whatever lies ahead.

During stressful and uncertain economic times such as these, please do not hesitate to look to your advisor for council! Our advisors always plan with our client's best interest at heart.

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