With inflation continuing to rise in today’s economy, how do we best plan clients’ portfolios to combat this issue? There is no surefire way to beat the inflation problem, but there are several strategies which can help defend against the current economic situation. With CPI currently running upwards at 3% and rising, there definitely needs to be some sort of method implemented to aid portfolios performance. To add to the inflation mess, interest rates aren’t rising in concordance with the inflation, in fact the yield on the 10-year Treasury note has fallen from 3.74% to under 3%. Normally these drops in interest rates would signify deflation but instead we are experience what is called stagflation: an inverse relationship between rising inflation and falling interest rates.
We haven’t experienced something quite like the current economic situation since the 1970’s. In the aftermath of World War II we also experienced a similar situation and therefore it is wise to analyze how stocks and bonds performed in these two periods in order to plan for our present position. During the 1940’s, large-company stocks yielded a 11.4% return which was well ahead of inflation at the time and the small- company stocks did even better with an average of 65% over the three year period of 1942-1945. But while stocks were cheap and gaining great returns, bonds were barely keeping up to the level of inflation, yielding less than 2% compounded. Although bonds weren’t necessarily losing any capital, investment in them did not provide the needed growth to keep up with the rate of inflation.
One possible strategy to investing in a period of high inflation is the consider gold as an inflation hedge. Two gold-mining stocks were analyzed during the 1970’s, The Barron’s Gold Mining Index and the Van Eck International Investors Fund. BMGI showed compounded 6.5% from 1975-1981 but then lost over 37% in the final year after the peak in gold prices while Van Eck grew at over 22% annually despite three years with losses of 20% of greater. Gold can be a great asset for growth during inflationary periods but should be taken with caution because gold stocks are nearly 2.5 times more volatile than the average stock. As quoted by advisorperspecitves.com, ” Clients want more of anything when it is going up substantially. The problem is, they rarely have a plan of for when to get out. Most people cannot deal with the downside volatility that is inherent in investing in the stock market and it worsens with precious metals stocks”. There needs to be managed risk in the portfolio if gold is to be hedged.
In analyzing the previous two high inflationary periods in our country’s history, we see that small stocks outperformed inflation in both periods, large stocks outperformed in the 1940’s but lagged in the 1970’s. Gold and gold stocks weren’t investable in the 1940’s but did well in the 1970’s but with noted volatility. Lastly, bonds lagged significantly in both inflationary periods. Obviously bonds are noted to be the most vulnerable to poor relative returns based on history during periods like today.
Although history has indicated certain patterns during periods like today, this does not mean that it will repeat itself. Past performance does not guarantee future. As advisorperspectives.com states, “At present, we see both inflationary and deflationary forces. Prices are rising for food, energy and healthcare, while interest rates are falling, the economy is slowing and housing in particular is distressed. This is stagflation — inflation with slow economic growth and relative high unemployment — such as took place in the 1970s”. In this current situation, treading water with your portfolio may be the best we can ask for.