Investors haven't had to worry about inflation for a long time. Many on Wall Street think that could be about to change.
Since the global financial crisis, now more than a decade ago, the U.S. economy hasn't seen much in the way of surging prices. If anything, economists have wondered why prices for many goods weren't climbing faster. Now, with the U.S. government adding several trillion dollars to the deficit in the wake of the COVID pandemic, Wall Street pros are suddenly talking about inflation risks again.
Jerome Powell, chair of the Federal Reserve, can’t seem to avoid being asked if he’s worried about the topic. While he’s yet to respond with an emphatic “no,” Powell has brushed off concerns that big price increases are coming.
In testimony before the House Financial Services committee this week, Powell said the Fed expects higher inflation this year, though not of the “particularly large nor persistent” variety. “We remain strongly committed to inflation expectations anchored at 2% and we'll use our tools, as appropriate, to achieve that.”
Just how worried are professional investors? Higher-than-expected inflation now is the biggest risk for markets, according to 37% of respondents in Bank of America’s monthly fund manager survey. And some of the rest of us must be, too, because there’s been a spike in Google searches for “how to hedge against inflation” this year.
Higher inflation is generally considered to be bad for bonds because their interest payments are usually fixed, and rising prices reduces their purchasing power. The effect on stocks, however, is mixed. Higher inflation is likely to be accompanied by more volatility in stock prices, and value stocks that benefit from faster economic growth could outperform growth stocks. Either way, investors may seek higher investment returns that outpace the higher rate of inflation.
“Obviously, inflation has been a little bit of a hot-button topic,” notes Charlie Ripley, vice president of portfolio management for Allianz Investment Management. Market participants are divided into two camps: Those who believe inflationary pressures will be short-lived versus those who believe a new regime has begun in which higher inflation will persist, he adds.
Why investors are worried about inflation
To be fair, inflation is creeping up, albeit slowly. The consumer price index (CPI) increased 1.7% in the 12 months through February, following a 1.4% gain for the year through January, according to figures from the Bureau of Labor Statistics. The Fed’s preferred measure of inflation, personal consumption expenditures (PCE), has also been rising — and the report for March is due on Friday, which will likely add more fuel to the already-raging debate.
The cause for concern about inflation is a combination of factors — federal stimulus packages have put extra money in the pockets of consumers who have pent-up demand to go out and spend again, Covid-19 vaccination rollouts have helped the economy reopen, and accommodative monetary policy has helped keep interest rates low. “All of that sets the backdrop for an upward inflationary environment,” Ripley says.
While there may be some “pretty big” increases in inflation measures in the months to come, as the economy normalizes again, so too will inflation, argues Jeff Buchbinder, market strategist for LPL Financial. “The drivers of inflation are going to look a lot like they did two years ago, pre-pandemic.”
Longer term, Buchbinder says four dynamics will likely suppress inflation: The Amazon effect on comparison shopping that helps keep consumer prices in-check, globalization that allows companies to move production to low-cost regions, technology advancements that reduce costs, and slower population growth that will cap gains in the labor market.
How to protect your portfolio against inflation
Whichever camp ends up being correct doesn’t matter so much because inflation concerns are already playing out in markets. The yield on the benchmark 10-year Treasury note jumped from about 1% in late January to above 1.7% this month, while the stock market has lurched around. In the past month, it took less than 20 days for the S&P 500 to notch a total of nine daily moves up or down in excess of 1% — a feat that took nearly 47 days previously.
“We expect more volatility because rates have moved really far, really fast,” Buchbinder says.
To navigate choppiness in conventional assets, some investors may look elsewhere, like TIPS (Treasury Inflation-Protected Securities), corporate bonds, commodities or real estate, Ripley notes. “Those all tend to perform pretty well in an inflationary environment.”
In addition to focusing on bonds that have shorter maturities, Buchbinder says investors may want to allocate more money to value rather than growth stocks. That’s because value stocks are better positioned to benefit from accelerating economic growth, rising interest rates and rising inflation, he adds.
But both Buchbinder and Ripley agree that the prospect of higher inflation shouldn’t prompt a complete portfolio overhaul. That’s because Wall Street’s worry about higher inflation is just that for now: A worry.
“Everything is just a forecast of what we’re expecting to happen when the economy reopens, and we have to see what happens if more of that forecast becomes a reality,” Ripley says.