Signs of accelerating inflation add a new dimension to the market recovery from the lockdown, forcing investors to make tough 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, leading them to seek out alternatives that may be even more flawed. Inflation fears rocked stocks, pulling major indices to record highs. Some have even referred to bitcoin as an inflation bet, but it fell 30% in a trading session last week.
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The challenge facing investors was evident this month when new data showed a surprisingly large rise in consumer prices. Rather than rising, a set of assets typically supposed to protect investors against inflation fell after the report.
The price of the inflation-protected 10-year Treasury benchmark registered its biggest one-day drop in a month. Real estate investment trust stocks slipped the most since January. Commodities were generally stable but fell the next day.
All three asset classes have since faltered, but their initial moves showed the unexpected ways in which markets can behave when inflation rises, especially when many are already expensive by historical measures.
This week, investors will have a better look at the inflation picture when the Commerce Department updates the Federal Reserve’s preferred inflation gauge, the Personal Consumer Expenditure Price Index. They will also track the revenues of companies like Dollar General Corp.
, Costco Wholesale Corp.
and Salesforce.com Inc.
The stakes are high for investors. Inflation lowers the value of government and traditional corporate bonds because it reduces the purchasing power of their fixed interest payments. But it can also hurt stocks, analysts say, by driving up interest rates and raising input costs for companies.
From early 1973 to last December, stocks generated positive inflation-adjusted returns in 90% of the rolling 12-month periods that occurred when inflation – as measured by the Consumer Price Index – was less than 3% and increasing, according to a study by Sean Markowicz, strategist at Schroders, the British asset management company. But that figure fell to just 48% in periods when inflation was above 3% and rising.
A recent report from the Ministry of Labor showed that the consumer price index jumped 4.2% in April from the previous year, from 2.6% in March. Even excluding volatile food and energy prices, it was up 3% from a year earlier, pushing past analysts’ expectations for a gain of 2.3%.
Analysts say there are many reasons why inflation will not be able to maintain this pace for a long time. The latest year-over-year figures have been inflated by comparisons with deeply depressed prices since the early days of the pandemic. They have also been supported by supply bottlenecks that many see as fixed, robust consumer demand that could dissipate once households have passed the government’s stimulus checks.
Prior to the pandemic, inflation spent years struggling to exceed the Fed’s 2% annual target, in part due to structural factors such as an aging population in developed countries. Analysts say these forces remain, although many will not rule out higher inflation and argue investors could prepare accordingly.
“We are going through an unprecedented situation – the exit from a pandemic accompanied by very favorable monetary and especially fiscal policies,” said Roberto Perli, head of global policy research at Cornerstone Macro.
Protection against inflation is tricky, however.
Inflation-Protected Treasury Securities, or TIPS, offer the simpler option because their interest payments and principal automatically increase when the CPI rises. When investors buy TIPS, the yields on the securities are lower than on nominal T-bills of the same maturity, but investors may ultimately earn a better return based on the rate of inflation over the life of the bond.
On Friday, the 10-year TIPS yield was minus 0.826% – meaning investors would lose money in the absence of inflation – compared to 1.629% for the 10-year Treasury bill.
This means that 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.
For some, this makes TIPS the safest and best inflation hedge. Investors are almost guaranteed to get their capital back if they hold the bonds to maturity. At current yield spreads, they can earn much more than regular Treasuries if inflation fears materialize.
Still, TIPS returns are likely to be paltry in almost any scenario, especially if inflation is below expectations. TIPS prices may also fall with regular T-bills – as they did after the CPI report – when investors believe that rising inflation will cause the Fed to raise interest rates to the next level. short term.
“When and if the Fed decides it’s time to fight inflation and raise rates, real TIPS returns will lead to losses, even if there is inflation,” Jim said. Vogel, Interest Rate Strategist at FHN Financial.
History suggests that there might be better hedges than TIPS when inflation is particularly high. According to Dr. Markowicz’s research, TIPS returns exceeded inflation in 71% of periods when inflation was below 3% and rising, but only 63% of periods when it was above 3% and in rise.
By comparison, the S&P GSCI Commodity Total Return Index produced positive inflation-adjusted returns in 83% of periods of high and rising inflation. “Raw materials are a source of input costs for companies and they are also a key part of the inflation index, which by definition you are trying to hedge,” Mr Markowicz said.
At the same time, commodities are among the most volatile of all asset classes and can be influenced by a range of idiosyncratic factors.
As it stands, many investors are bullish on the long-term outlook for commodities, from corn to copper, arguing that prices may rise even after a significant rebound this year. Commodities, they say, could be supported by continued strong consumer demand 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 well below the peak reached before the 2008-09 financial crisis.
Yet “the system itself is very delicate,” he said. Anything that changes the supply or demand for commodities “can change the price either way.”
—Amrith Ramkumar contributed to this article.
Write to Sam Goldfarb à [email protected]
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