More inflation is coming and that could hurt your portfolio – at least in the short term.
Inflation was a buzzword year-round as supply chain problems and additional savings by US consumers drove up prices for goods from homes to cars to bacon. Consumer prices rose 6.8% year over year in November, the fastest price increase since 1982.
So far, rising prices have done little to suppress a sharp rally in the stock market, with the S&P 500 forecasting gains of nearly 24%. That doesn’t mean market participants aren’t worried, however, especially since the Federal Reserve has announced plans to hike rates three times in 2022 to contain price hikes.
The biggest risk to the market, according to a monthly Bank of America survey of fund managers, is an over-aggressive rate hike strategy by central banks, followed by inflation. Meanwhile, 25% of Americans say rising inflation is the single biggest risk to their retirement savings, a percentage that has more than doubled since 2020, according to an annual study by Allianz Life Insurance Company of North America.
How worried do you need to be about inflation and the Fed’s response to it? Not much. In the short term, there is likely to be more market volatility and stock prices could plummet as borrowing costs have risen and companies may have to bear the higher cost of raw materials or labor before they can pass price increases on to their customers.
Over time, however, the impact becomes less apparent as stocks offer “pretty good hedge” against higher inflation, notes Ross Mayfield, an investment strategy analyst at Baird. “In general, the stock market has done quite well over the past 40 to 50 years during periods of higher inflation.”
A notable exception was the 1970s, when stocks fell into a bear market during a period of stagflation (persistently high inflation combined with high unemployment). And since inflation hasn’t been a concern for investors in recent years, some market watchers have pointed to the 1970s as a warning – a comparison Mayfield believes is unjustified.
“The economic backdrop is really very different today,” notes Mayfield, adding that the job market is “as strong as we have seen it in decades.” As a result, if companies raise prices now, consumers can, by and large, “digest” those price increases in order to maintain their spending. “There is no need to fear inflation.”
How inflation affects companies
Headline inflation hides some of the big differences in price increases (or even decreases) across industries. Just as it is important for consumers to calculate a “personal” rate of inflation, investors should consider how higher inflation could affect the stocks in your portfolio.
Companies that buy raw materials will feel the higher raw material prices immediately, while companies that sell manufactured goods or provide services may have a delayed effect of the rising costs of transporting items and paying workers. During times of high inflation and high interest rates, investors tend to prefer value stocks – including those in the basic materials, industrial, financial, energy and consumer staples sectors, Mayfield notes. Some growth stocks, including tech companies, have also performed well over similar time frames because of the ability to pass price increases on to an entrenched customer base, he adds.
While some investors may seek to change their portfolios to capture the different effects of higher inflation, it can also be argued that they should focus on diversifying their portfolio. “It’s important to really get your exposure across stocks, bonds and real assets,” advises Eric Freedman, US Bank’s chief investment officer.
It is also very important to stay invested in the market even as stock prices become more volatile as market participants try to understand higher inflation and what the Fed is doing to raise interest rates. Freedman and his colleagues predict that the S&P 500 will end the year at 5,060 points – up almost 9% from its current level.
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Arguments for ignoring inflation altogether
Just as the market seems to have wiped inflation worries away this year, there are reasons for investors to do the same. That’s because higher inflation is a factor in both supply and demand problems that are inextricably linked to the pandemic; The supply chain problems are partly to blame, while demand has increased in part due to stimulus checks to Americans.
“It’s hard to separate traditional inflationary pressures from cause and effect of pandemic problems,” Mayfield says. This dynamic has also challenged central bankers, who initially described inflation as “transitory” and have more recently changed their strategy.
With uncertainty surrounding the pandemic still high, volatility is likely to continue as investors see higher inflation and higher interest rates ahead. Even so, stocks continue to offer the best return for investors – and Mayfield points out that large-scale portfolio changes are not warranted for long-term investors.
“Take a long-term perspective,” Freedman adds. “Have a plan and have the opportunity to reconsider that plan if the facts change.”
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