5 Ways to Position for Stubborn Inflation
After 40 years of declining inflation, could this be a new era of stubbornly above trend inflation? The specter of both rates and inflation remaining higher for longer requires investors to exercise patience — and inflation-busting savvy when it comes to positioning portfolios.
Core CPI growth for March came in hotter than expected at 3.5% year-over-year, versus expectations of 3.4%.1 And with every print since September surprising to the upside, CPI is moving further away from the Federal Reserve’s 2% target.
Could sticky inflation transform into another wave of price surges? Notably, analysis from Strategas Research Partners finds that multiple waves of inflation are common — with a second wave of US inflation starting on average 30 months after the first peak.2 The US is now almost 22 months past the June 2022 peak in CPI.
How can you position portfolios to withstand persistent inflation?
Play Defense with Treasury Inflation-Protected Securities
To fight inflation’s erosive effects, consider replacing your nominal Treasury exposure with Treasury Inflation-Protected Securities (TIPS), either completely or in a 50/50 blend.
Because their principal value rises and falls in lockstep with CPI, adding TIPS without reducing your fixed income allocation will extend your portfolio’s duration profile and dilute the potential relative value opportunity, as duration effects will be the predominant driver of risk and return. After all, TIPS are still bonds and the inverse relationship between prices and yields still holds.
TIPS ETFs to consider:
Go for Gold, the Oldest Inflation Sensitive Solution
As a unique store of value, gold never loses its luster, helping to preserve purchasing power over time. In fact, we advocate for gold’s strategic role in portfolios for this very reason, among others (e.g., volatility management).
While the price of gold tends to keep pace with general price fluctuations, its overall inflation sensitivity during periods of low or moderate price changes has been average compared to other asset classes. Yet, in moderate levels (between 2 and 5%) it did, on average, outperform similarly defensive-minded US Treasurys.3
Gold has been most effective during periods of sizeable above trend inflation readings. Over the past 50 years, gold has provided an average annual real return of 10.35% when US CPI exceeded 5% year-over-year, compared to negative returns on average for, both, global and US equities as well as US Treasurys.4 While we’re unlikely to break above that 5% barrier in the near term, gold continues to set new all-time price records amid this current bout of stubborn inflation and robust fundamental and central bank demand.
Gold ETFs to consider:
Play Offense with Natural Resources
Energy, Industrials, and Materials are three of the top four sectors with the highest sensitivity to inflation, based on excess returns of the 11 GICS sectors compared to the S&P 500® Index versus 2-year breakeven inflation rates (Figure 1). Financials completes the top four with the third-highest sensitivity, given the historical impact inflation has on interest rates.
Higher inflation may lead to higher commodity prices and an uptick in demand for natural resources. To pursue the potentially higher profits for natural resource companies, consider the:
Target Natural Resources, With an Eye Toward Smaller Companies
Because their business operations are less diversified than those of larger firms, mid-caps and small caps tend to be more reliant on the spot price of a commodity. Smaller metals and mining firms also tend to have higher leverage ratios which, when combined with revenue more focused on one business line, mean the impact from one revenue driver changing may be greater due to the operating leverage being used to run the business (Figure 2).
The S&P Metals & Mining Select Industry Index is a targeted segment of the Materials sector, where the smaller firms have higher leverage ratios and a higher beta sensitivity to breakeven rates (Figure 3). As a result, a modified equal-weighted industry approach more fairly allocated across the Natural Resource sector’s cap spectrums may allow investors to harness higher inflation sensitivity without excessive single-stock risk due to the weighting scheme.
For Natural Resources industries that showed greater sensitivity to inflation than broader sectors, consider these ETFs:
- SPDR® S&P Oil & Gas Equipment & Services ETF [XES]
- SPDR® S&P Oil & Gas Exploration & Production ETF [XOP]
- SPDR® S&P Metals & Mining ETF [XME]
Choose a Real Asset Sector Rotation Strategy
Regardless of inflation’s future path, there are strategic reasons to add a diversified real asset sector rotation strategy that offers exposure to multiple real assets or inflation-sensitive sectors. Many of today’s portfolios are likely overweight both mega-cap growth equities and bonds that will be challenged on a real return basis, making now a reasonable time to overlay a multi-asset real asset strategy that allocates to multiple inflation-sensitive markets beyond commodities, including: gold, inflation-linked bonds, infrastructure, real estate, and natural resource equities.
For a multi-asset approach, alongside prudent risk management imbedded in the active process, and where the overall volatility has the potential to be less than what is found in a single commodity sleeve, consider the following ETF:
Higher for Longer Inflation?
Stubborn inflation in tandem with high interest rates will continue to create investment challenges as the Fed tries to strike the delicate balance needed to achieve a soft landing. The central bank doesn’t want to hurt the job market or cause a recession by keeping interest rates too high for too long. But the Fed also wants to avoid cutting rates too soon or by too much before getting inflation closer to its target.
The policymakers’ waiting game requires investors to exercise patience — and inflation-busting savvy — as both rates and inflation look to remain higher for longer. And, there are solutions for investors to either play offense or defense when it comes to positioning portfolios now.
Looking for More Portfolio Positioning Insights?
Explore Market Trends for timely insights on the current macro environment, ETF flows, investor sentiment and more. Or check out this quarter’s Bond Compass for PriceStats inflation data and the latest ETF playbook for bond investors.