Retirees have long complained about not making much on CDs, money market funds and the like.
They may soon have to find something else to complain about.
Yes, inflation is on the rise and retirees must now consider repositioning not only their short-term safe-haven investments (we’ll talk more about that in part two) but also their portfolio (which we will focus on here).
Well, by the way, is the subject (and title) of an article soon to be published in the Journal of Portfolio Management by Campbell Harvey, a professor at Duke University, and several of his colleagues associated with co-authored with Man Group. .
What to do with your long-term portfolio?
And here’s what Harvey and his co-authors discovered after studying eight periods of inflation since 1925: Neither stocks nor bonds do well in real terms during periods of inflation. development is studied. Real is the nominal rate of return minus the inflation rate.
Furthermore, Harvey and his coauthors found that no individual equity sector, including the energy sector, offers significant protection against high and rising inflation.
So what strategies work?
Treasury inflation-protected securities (TIPS) are very robust when inflation rises, giving them the benefit of producing similar real returns in inflationary and non-inflationary regimes, the authors write. inflation, both positive.
In fact, TIPS has had a real annualized return of 2% for the most recent five inflationary periods.
But what looks promising in a research paper may not work in practice given the current yield on TIPS (0.872% as of June 2, 2021). Low yields mean TIPS is a “really super expensive” hedge against future inflation, said Harvey.
“That means you get negative returns in periods of no inflation,” he said. “So yes, they offer protection, but they’re an expensive way to get that protection.”
“Tradable commodities” have historically performed best during periods of high and rising inflation. In fact, traded commodities have a “perfect track record” of generating positive real returns over the eight periods studied in the United States, averaging 14% real annual returns. .
Now, investors may not be able to trade commodities in the same way as institutional investors use futures, said Harvey, but they can invest in ETFs that invest in a basket. vast merchandise.
Residential real estate on average holds its value during periods of inflation, although not nearly as much as commodities. Collectibles such as art (7%), wine (5%) and stamps (9%) also have high real returns in times of inflation.
And while some suggested adding bitcoin
for a diversified portfolio as an inflation hedge asset, caution is warranted as bitcoin has not been tested with quality data for only eight years — in a period that lacks a single inflationary period, the authors write. “It’s not just untested,” said Harvey. “It’s too volatile.”
Gold is also too volatile as a reliable hedge against inflation. For example, Harvey notes that gold’s performance since 1975 has been largely driven by a single year, 1979, when gold rose significantly in value. “And that makes the average look really good,” he said.
Harvey also said his number one dynamic strategy in times of inflation is to change the level of industry risk in your portfolio. With this strategy, you will allocate a large portion of your wealth to sectors that previously performed well during inflation, such as medical equipment, and less if anything to sectors. perform poorly during periods of inflation, such as consumer durables and retail. “You can naturally rebalance your portfolio to be a little more defensive,” he said. “And that can be done by any investor.”
Harvey and his co-authors also found that active capital factors often hold themselves up during periods of high inflation with “quality stocks” with small positive real returns and “value stocks” with high returns. small negative profit.
According to Harvey, dynamic strategies are “proactive” strategies that involve monthly portfolio rebalancing. In contrast, passive strategies require minimal or no rebalancing; e.g. holding the S&P 500 index
Active capital multiplier investing uses frequent rebalancing to place bets that deviate from the investment weighting that a passive market portfolio implies. These bets are intended to generate higher and higher returns than passive market portfolios, Harvey said.
In Harvey’s research, quality is defined as a combination of profitability, growth and safety, and value is determined by traditional measures such as book-to-price ratio.
Now is the time to reposition your portfolio?
According to Harvey, an increase in inflation from 2% to more than 5% is bad for stocks and bonds. We are not there yet; The current inflation rate is 4.2%. But we’re getting close to the “red zone” and now would be a good time to “rethink your portfolio situation,” says Harvey. “So even if it doesn’t happen, it doesn’t matter. If the risk is high enough, you take some action, you’re essentially buying some insurance.”
And being proactive is key. “So, at least for now, it’s better to discuss now than when it’s too late; Harvey said.
Also remember that what you’re hedging is “unexpected” inflation, says Harvey. “What you really care about is unexpected inflation or unexpected inflation. We call it an economic shock.”
But not a momentary shock. That will not affect the asset price. “You need to look at inflation in the long run,” he said.
And the place to look for that is in breakeven inflation rate (BEI) reflected in TIPS and Nominal Treasures. The BEI is the weighted average of inflation expectations over the life of the bond. And changes in the BEI have the advantage of reflecting changes in long-term or permanent inflation expectations. Currently, the BEI is 2.44%. “Anything that is a long-term measure of inflation will maximize asset prices,” he said.
As for the current inflationary environment, Harvey said it’s a mix of transient and non-transient factors. Wood prices increase but may not be permanent. However, increases in the prices of other goods and services may not be temporary. “Obviously it’s very difficult to dissect this,” he said. “But it’s really important for people who are running a portfolio to draw that distinction.”