​​Inflation Considerations: Preparing Your Portfolio For Future Risk

The Federal Open Market Committee of the Federal Reserve aims for 2% inflation per year. It carefully targets just enough inflation to cause stability in the United States economy without burdening prices. In a 2016 report on the FOMC’s long-term goals, the committee reported it would “be concerned if inflation were running persistently above or below this objective.”

With current inflation exceeding the Fed’s target and no immediate signals of slowing down, what preparations can you make today to prepare your portfolio for potential future inflation risk?

Current State

Each of the first two quarters of 2021 indicated economic recovery for the United States. Not only did GDP grow 6.3% in Q1 and 6.6% in Q2, the jobless rate decreased in all 50 states from one year ago. The national unemployment rate in July 2020 was 9.6%. A year later, the national unemployment rate is 5.4% with 943,000 jobs having been added during July 2021.

Unquestionably, this economic recovery is a result of government fiscal stimulus. In response to the COVID-19 pandemic, the United States government infused an unprecedented amount of money into the economy. Since the beginning of the pandemic, the government has increased the amount of dollars in circulation by 27%. For perspective, the fiscal stimulus response to the 2007-08 Financial Crisis increased the money supply by 10%, and Franklin D. Roosevelt’s response to the Great Depression only increased the American money supply by 10%. Through the summer of 2021, 478 million individual stimulus payments have been sent to American citizens.

Inflation Expectations

Because of the unprecedented economic situation, the long-term impacts of the recent government intervention are yet to come to light. However, the largest looming risk related to the increased money supply is inflation. Federal Reserve chairman Jerome Powell noted,

"Inflation has increased notably and will likely remain elevated in coming months before moderating".

A recent survey by the Federal Reserve of New York reported consumers expect average price increases of 3.7% over the next three years. A similar survey by the Federal Reserve of Michigan in July 2021 noted expected inflation of 4.7% over the next 12 months.

A Look Back

The United States has a history battling high inflation. The period between 1965 and 1982 is commonly referred to as The Great Inflation. In 1964, annual inflation stood at a little more than 1%. Then, the economy was burdened by resource demands from the Vietnam war and by the Great Society legislation introduced by Lyndon B. Johnson. In addition, the Arab Oil Embargo in 1973 and the Irian Revolution in 1979 put repeated stress on energy prices. By 1980, annual inflation was 14.7%.

To combat rising prices, newly appointed chairman of the Federal Reserve Paul Volkner targeted the money supply as opposed to manipulating  interest rates. In Q3 of 1981, high interest rates pressured the manufacturing and construction sectors and the economy officially entered a recession. Though unemployment exceeded 10%, Volkner successfully held his ground - by October 1982, inflation had fallen below 5%. Unemployment dropped to below 8% the following year, and double-digit inflation has never returned since.

Preparing for Future Risk

There’s a number of ways to prepare your portfolio for inflation. Long-term bonds don’t do as well during inflationary times  as periodic fixed-rate coupon payments lose purchasing power over time. Unfortunately, short-term bonds with less sensitivity to changes in price typically have low yields with potential negative real returns. The principal balance of Treasury inflation-protected securities (TIPS) is adjusted by inflation each year, though expect modest returns in exchange for this mitigated risk. In addition, credit risk transfer securities (CRTs) are floating-rate bonds backed by real assets. CRTs offer higher yields due to higher default risk of the underlying real property.

Equity investments are directly impacted by inflation due to underlying impacts of operating the companies. Businesses will feel pricing pressure on wages and raw materials, so invest in companies with high profit margins or low costs allocated to labor. Businesses with high fixed-rate debt stand to benefit during inflationary periods - as long as they can continually service their debt. Though riskier, companies with smaller equity market capitalizations tend to outperform companies with larger market capitalizations.

Specific sectors tend to perform better during inflationary periods. Because the energy, industrials, and materials sectors do not rely on acquiring commodities at inflated prices, these sectors tend to outperform other areas of the economy in high inflationary times. In addition, holding emerging-market stocks in commodity-producing nations (i.e Brazil or Russia) hedges against the risk of domestic increasing prices.

Outside of traditional stocks and bonds, alternative investments have proven to provide excellent diversification opportunities. Gold, silver, and other precious metals with limited supply are popular choices to hedge against inflation, though gold typically excels primarily in periods of extreme inflation. Cryptocurrencies with limited supply fall into the same category, though they are more speculative given their shorter history as a store of value. Be prepared for principal loss as Bitcoin is 2.4 times as volatile as the S&P 500.

Hedging Against Inflation with Real Assets

One additional alternative investment that has historically performed great during inflationary periods is real assets. Not only do real assets historically preserve their underlying value, they also have the ability to earn passive income through rental payments or commodity production. Over the past 30 years, an index of U.S. real estate investment trusts posted bigger gains than the S&P 500 in five of the six years when inflation was 3% or higher. In addition, private timberland investments were found to have a stronger correlation to inflation than stocks, bonds, or commercial real estate.

An investment with a very strong hedge against inflation is farmland investing. Farmland has a 70% correlation with the CPI and a 79.84% correlation with the PPI. Over the past 50 years, the value of American farmland has outperformed almost every other asset class by rising an average of 6.1% per year. It’s also had less average volatility than the 10-year Treasury bond, S&P 500, gold, or Dow Jones REIT Index. The economy during The Great Inflation experienced average annual inflation of 7.4%; during this period, farmland posted an annualized total return of 18.9 percent.

In addition, farmland produces inflationary commodities like grain or corn. Crop income provides a steady stream of income that can be variably priced over time in response to changing market conditions.. Over the past three decades, commodities have had a statistically significant positive inflation beta. Research by Vanguard Group suggests that every 1% rise in unexpected inflation results in a 7% to 9% increase in commodity prices. Plus, the USDA projects corn and soybean prices to  rise between 18% and 30% during the 2020-2021 crop year.

Farmland: A Historically Superior Inflation Hedge

With nearly $6 trillion of government stimulus money hitting the American economy during 2020 and 2021, the long-term implications of pricing pressure in the United States is still to be determined. History has shown us that this type of change to the monetary supply creates market turbulence and high price hikes. If we do experience long periods of high inflation, farmland investments have historically proven to be a strong candidate to hedge against this risk.