Inflation Forces Investors to Scramble for Solutions
Signs that inflation is picking up momentum are adding a new dimension to the post-lockdown market rally, forcing investors to make difficult decisions about how to protect their portfolios from the emerging threat.
Investors have a variety of options at their disposal but face near-record prices for old standbys like gold, sending some searching for alternatives that may be even more imperfect. Inflation fears have buffeted stocks, pulling major indexes back from records. Some have even talked up bitcoin as an inflation bet, but it fell as much as 30% during a trading session last week.
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The challenge facing investors was apparent this month when new data showed a surprisingly large jump in consumer prices. Rather than rise, a collection of assets generally thought to safeguard investors against inflation fell after the report.
The price of the benchmark 10-year Treasury inflation-protected security logged its biggest one-day decline in a month. Shares of real-estate investment trusts slid the most since January. Commodities were generally flat but dropped the following day.
The three asset classes have vacillated since, but their initial moves showed the unexpected ways that markets can behave when inflation is rising, especially when many are already expensive by historical measures.
This week, investors will gain greater insight into the inflation picture when the Commerce Department updates the Federal Reserve’s preferred inflation gauge, the personal-consumption-expenditures price index. They will also track earnings from the likes of Dollar General Corp. , Costco Wholesale Corp. and Salesforce.com Inc.
The stakes are high for investors. Inflation dents the value of traditional government and corporate bonds because it reduces the purchasing power of their fixed interest payments. But it can also hurt stocks, analysts say, by pushing up interest rates and increasing input costs for companies.
From early 1973 through last December, stocks have delivered positive inflation-adjusted returns in 90% of rolling 12-month periods that occurred when inflation—as measured by the consumer-price index—was below 3% and rising, according to research by Sean Markowicz, a strategist at Schroders, the U.K. asset-management firm. But that fell to only 48% of the periods when inflation was above 3% and rising.
A recent report from the Labor Department showed that the consumer-price index jumped 4.2% in April from a year earlier, up from 2.6% in March. Even excluding volatile food and energy prices, it was up 3% from a year earlier, blowing past analysts’ expectations for a 2.3% gain.
Analysts say that there are plenty of reasons why inflation won’t be able to maintain that pace for long. The latest year-over-year numbers were inflated by comparisons to deeply depressed prices from the early days of the pandemic. They were also supported by supply bottlenecks that many view as fixable and robust consumer demand that could dissipate once households have spent government stimulus checks.
Before the pandemic, inflation spent years struggling to climb above the Fed’s 2% annual target due in part to structural factors like aging populations in developed countries. Analysts say those forces remain, though many won’t rule out sustained higher inflation and say investors might prepare accordingly.
“We are going through an unprecedented situation—exit from a pandemic accompanied by very supportive monetary and especially fiscal policies,” said Roberto Perli, head of global policy research at Cornerstone Macro.
Protecting against inflation is tricky, however.
Treasury inflation-protected securities, or TIPS, offer the most straightforward option, as their interest payments and principal automatically increase when the CPI rises. When investors buy TIPS, the yields on the securities are lower than nominal Treasurys of the same maturity, but investors can ultimately earn a better return depending on the rate of inflation over the life of the bond.
As of Friday, the yield on 10-year TIPS was minus 0.826%—meaning investors would lose money absent any inflation—compared with 1.629% for the nominal 10-year Treasury note.
That means CPI growth would need to average at least 2.45% over the next 10 years for the inflation-protected security to pay as much or more than the nominal Treasury.
To some, this makes TIPS the safest and best inflation hedge. Investors are nearly guaranteed to get their principal back if they hold the bonds to maturity. At current yield differentials, they can earn significantly more than regular Treasurys if inflation fears are realized.
Still, TIPS returns are likely to be paltry under almost any scenario, particularly if inflation comes below expectations. TIPS prices can also fall along with regular Treasurys—as they did after the CPI report—when investors think rising inflation will push the Fed to raise short-term interest rates.
“When and if the Fed decides that it is time to fight inflation and raise rates, real yields in TIPS are going to cause losses, even if there’s inflation,” said Jim Vogel, an interest-rates strategist at FHN Financial.
History suggests there might be better hedges than TIPS when inflation is especially high. According to the research by Mr. Markowicz, TIPS returns exceeded inflation in 71% of the periods when inflation was below 3% and rising, but only 63% of periods when it was above 3% and climbing.
By comparison, the S&P GSCI Commodity Total Return Index delivered positive inflation-adjusted returns in 83% of the high and rising inflation periods. “Commodities are a source of input costs for companies and they’re also a key component of the inflation index, which by definition you’re trying to hedge,” said Mr. Markowicz.
At the same time, commodities are among the most volatile of all asset classes and can be influenced by an array of idiosyncratic factors.
As it stands, many investors are optimistic about the long-term outlook of commodities, from corn to copper, arguing that prices have room to rise, even after a significant rally this year. Commodities, they argue, could be supported by continued strong demand from consumers and relatively limited supply, as many natural-resource companies take a conservative approach to production.
Darwei Kung, head of commodities and portfolio manager at DWS Group, noted that the widely tracked Bloomberg Commodity Index remains far below the peak it reached before the 2008-09 financial crisis.
Still, “the system itself is very delicate,” he said. Anything that changes supply or demand for commodities “can change the price both directions.”
—Amrith Ramkumar contributed to this article.
Write to Sam Goldfarb at email@example.com
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Published at Sun, 23 May 2021 09:33:00 +0000