By Philip van Doorn
Inflation is back, and the question for investors is whether it is a blip caused by pent-up demand as the economy opens up. If you believe a sustained period of high inflation has begun, this is the time to reconsider your investment allocation.
Economists cite contradictory evidence when discussing the broad movements of prices for assets, goods and services, so your own opinion might be as good an indicator of the inflation threat as any other.
What follows are comments from an economist and three money managers that might point you in safer directions in an environment of higher inflation and rising interest rates.
First, we’ll consider defensive moves for income portfolios and then look at stocks.
Fear of rising interest rates
When interest rates rise, bond prices fall. For now, interest rates remain low, underscoring how some investors might have itchy trigger fingers if they see more signs of inflation. There’s plenty of real evidence, including a 2.6% increase in the consumer price index over the previous 12 months, which was the largest increase in two and a half years .
There’s also the inflation of asset prices: The broad stock indexes are near record levels, which itself isn’t necessarily a bad sign. But their price-to-earnings ratios are high. For the S&P 500 /zigman2/quotes/210599714/realtime SPX +0.67% , the aggregate forward price-to-earnings ratio is 22.2, compared with 17.2 two years ago, according to FactSet.
Then turn to the U.S. housing market: The S&P Case-Shiller 20-city home price index was up 11.9% in February from a year earlier. Rental markets are strong outside the largest U.S. cities and are recovering in several of the biggest ones.
Then there’s anecdotal evidence. If there have been houses for rent in your neighborhood, maybe you have noticed a lot of people driving by to check them out.
And have you tried to buy lumber this year? You may be in for a rude awakening.
“Take note of the anecdotal. It tends to be a leading indicator to the official data,” said Michael Cuggino, president and portfolio manager of the Permanent Portfolio Family of Funds, which is based in San Francisco.
Cuggino said the quick spike in yields for 10-year U.S. Treasury notes /zigman2/quotes/211347051/realtime BX:TMUBMUSD10Y +4.44% that started in mid-February “was partially in response” to the risk of inflation.
He said there’s no comparison between the 2021 recovery from the coronavirus pandemic slowdown to the bounce-back that followed the credit crisis of 2008. The response by the government and Federal Reserve today dwarfs that of the financial meltdown of a dozen years ago.
Plus, money today is going to Main Street — extended and increased unemployment benefits, moratoriums on foreclosures and evictions, among other programs. During the previous crisis, banks were bailed out and stocked with liquidity. “Our banking system is very strong as a result,” he said.
Matthew Pallai, the head of multi asset solutions at Harbor Capital Advisors, concurred.
“It is fairly new that fiscal stimulus has been paired with monetary stimulus. Those two forces are working together to put upward pressure on inflation,” he said.
“So you are starting with very low production numbers (and now) have increased liquidity chasing around fewer goods and services,” Cuggino said.
Moves you can make
Patrick Zweifel, the chief economist at Pictet Asset Management, said: “As long as inflation is essentially driven by strong growth — demand-driven inflation — risky assets tend to perform well.” Those include high-yield bonds and stocks, he said.
Pallai said “right now, we are more likely seeing demand-driven inflation” than supply-side inflation, because “the consumer is in a pretty good spot from an income perspective, from a savings perspective — better than it has been in quite some time.”
During a period of high demand and high inflation, Zweifel expects traditional inflation hedges — gold, other commodities and housing — to perform well. But he would expect even better performance from gold and commodities if the environment were to change again, to one of high inflation and slower growth.
The price of gold, based on continuous forward-month futures on the New York Mercantile Exchange /zigman2/quotes/201432642/composite GOLD -1.70% , has increased only 13.5% over the past 10 years, according to FactSet. Cuggino said opinions of gold are closely tied to investors’ time range.
“When interest rates rise, gold goes down from the knee-jerk reaction. Then gold inches back up,” Cuggino said. So you should expect short-term volatility for gold if there is a strong market.
Cuggino pointed out how patient a gold investor might need to be: “From the early- to mid-1980s to 2000, it was in a trading range of $200 to $400 an ounce. It did nothing for 15 years.”
Then from 2000, gold rose to an eventual trading range of $1,179 to $1,924 in 2011-2013.