Inflation has turned from transitory to pernicious, with some economists even raising the specter of a 1970s-style wage-price spiral.
Should you reposition your investment portfolio for an inflationary environment, shifting some of your money to sectors or asset classes that tend to do well during inflationary periods? Or should you leave your investments alone and let the markets control their long-term destiny?
The answer depends in part on how long you expect inflation to last, and whether we are in a period of rising inflation.
“Not all equity sectors are created alike,” said Anu Gaggar, CFA, senior investment analyst at Commonwealth Financial Network. “Specifically, some can combat inflation and subsequent interest rate increases better than others. When inflation is low and rising, as is generally the case during the start of an economic cycle, it is good for equities.”
If the economy overheats, however, demand exceeds supply, leading to higher inflation expectations and rising interest rates.
“High and rising inflation dents consumer sentiment,” Gaggar said. “The market expects that our economy is heading this way, and it’s what is scaring investors.”
Threat Of Rising Inflation
Inflation rose to 7.9% in February, the highest since 1982 as measured by the Consumer Price Index. The costs of materials, labor and capital are rising for companies. At times, companies cannot pass on those higher costs to consumers. Corporate margins are then compressed, and expectations for lower future cash flows drag down stock prices.
We “have become increasingly concerned that inflation is heading higher for longer,” wrote Ed Yardeni, president and chief investment strategist at Yardeni Research, in his March 15 morning briefing. “Wages are increasing at a faster pace than they were pre-pandemic, but so are prices, which are offsetting the wage gains. We have become more concerned that productivity isn’t rising fast enough to stop the wage-price spiral anytime soon.”
Could that bring on an extended period of stagflation, with rising prices, lower wages and lower productivity?
Yardeni doesn’t think so. He foresees a soft landing for the economy, with inflation peaking by midyear, he said in a note April 7. He expects inflation will moderate to 3%-4% in 2023. But, he said, “Like everyone else, I am on alert for a recession.”
That leaves investors in a quandary. The last time the economy was in a long-term inflationary period was in 1968 to 1982. The S&P 500 closed at 108.37 in November 1968. At the end of July 1982, it stood at 107.09. Over nearly 14 years that works out to a total loss of 1.2%. Just to keep up with inflation, the S&P would have had to have risen to 298.02 points during that period.
“In theory, equities should offer a buffer against inflation because a rise in prices should correspond to a rise in nominal revenues and, therefore, boost share prices,” said Sean Markowicz, a strategist for London-based Schroders Investment Management. But in fact, “equities in general have performed quite poorly in high and rising inflation environments.”
And that brings up a good point. Even in the 1968-82 period when inflation was high, those years were interspersed by periods of high but declining inflation. For example, all of 1975 and 1976 were periods of high inflation but declining inflation rates. That happened again during 1981 and 1982. The S&P 500 did well during three of those four years, with the exception of 1981.
Stock Market Performance And Inflation
Looking at rolling 12-month periods when inflation was high and rising from 1973 to 2021, equity returns typically lagged inflation and on average were negative.
And how did various sectors perform during these periods? As the nearby graph shows, the sectors that outperformed during high and rising inflation are the same ones that are outperforming now. Technology was one of the worst-performing sectors.
Some sectors of the stock market historically performed better than the overall market. The energy sector, which includes oil and gas companies, is one of them.
“The revenues of energy stocks are naturally tied to energy prices, a key component of inflation indices. So by definition (they) generally have performed well when inflation rises,” Markowicz said. “Equity REITs (real estate investment trusts) may also help mitigate the impact of rising inflation. Equity REITs own real estate assets and may provide a partial inflation hedge via the pass-through of price increases in rental contracts and property prices.”
The one caveat to the nearby chart is that it fails to capture the extreme volatility of some of these sectors. Energy was a solid investment during high and rising inflation, beating inflation 70% of the time, according to Schroders. On the other hand, precious metals and mining produced an average 12-month inflation-adjusted return of 8% during such periods, but the sector’s performance wasn’t consistent. More than half the time it actually lagged inflation.
Energy, Health And Consumer Staples
The energy sector tends to make drastic spikes when the price of oil goes up or down, and those swings are often tied to inflation. You can gain exposure to oil and gas stocks by investing in an ETF such as iShares U.S. Oil & Gas Explorers & Producers (IEO), which through April 6 was up 38% year to date, or Energy Select Sector SPDR (XLE). Some oil stocks turned in much bigger gains, such as IBD 50 leader Occidental Petroleum (OXY), up 95% this year.
Compare the sector chart to the performance of the S&P sectors this year. Consistent with their historical performance during times of rising inflation, energy stocks are outperforming this year.
Despite their recent performance, Gaggar points to consumer staples as an inflation hedge as well. “Consumer staples also tend to hold their own during an inflationary regime as demand for staples generally tends to be inelastic,” she said.
Health care stocks also are expected to beat inflation over time.
Gold and precious metals — lumped in with the materials sector in the chart above — are considered a safe haven from inflation too. The problem is that they are extremely volatile.
REITs And Other Real Estate Investments
Real estate, including equity REITs, also can be worth considering when inflation is rising. Equity REITs are companies that own and operate income-producing real estate. They should not be confused with mortgage REITs, which are investments that purchase mortgages or mortgage-backed securities. Mortgage REITs are expected to underperform inflation.
An equity REIT makes money from the price of property and rents, which tend to rise when inflation rises. A REIT pays out most profits to shareholders through dividends in exchange for favorable tax treatment.
Or you can get them through an ETF such as the SPDR Real Estate ETF (XLRE), Vanguard Real Estate ETF (VNQ) or the iShares U.S. Real Estate ETF (IYR). All three of these REIT ETFs were down sharply earlier this year but have since come back, with 2022 returns through April 6 running from -4.5% to -5.6%.
Some of these REITs are also on the IBD Breakout Stocks Index. The IBD Breakout Stocks Index uses a combination of filters to find stocks that are at or near breakouts. It starts with the strongest stocks in both fundamental and technical performance, and then wraps in pattern-recognition algorithms to select breakout stocks that are at or approaching new buy points. Finally, the list applies weightings and sell rules.
Buying investment properties can also beat inflation. But keep in mind that residential and commercial real estate prices often rise when inflation rises, but don’t always.
Greg Bassuk, CEO at AXS Investments, says REITs and other liquid alternative strategies should pay off this year as we face periods of volatility and uncertainty. AXS is an alternative investment management firm.
Gold And Commodities
Gold is not the only commodity to consider in an inflationary environment. Commodities in general can benefit from inflation. Commodities are the raw materials — agriculture, metals and so on — that go into the equipment and other finished products that consumers and companies purchase.
Long-term investors can seek exposure through ETFs that invest in gold or other commodities. Invesco Optimum Yield Diversified Commodity Strategy No K-1 (PDBC) is an actively managed $7 billion fund that invests in commodity futures. It focuses on 14 heavily traded commodities across the energy, precious metals and industrial metals sectors, as well as agriculture. It was up 20% from a low on Dec. 20 through April 6.
Investors can also gain exposure through one of the largest and best-performing commodity ETFs (see chart).
Other choices are the S&P Gold Shares ETF (GLD), iShares Gold Trust (IAU) or the Aberdeen Standard Gold ETF (SGOL). But again, investors should keep in mind that gold’s performance during inflationary periods is inconsistent.
This year GLD soared as much as 12% during the height of Russia’s attack on Ukraine. As of now, it’s up 5% for the year through April 6, vs. a decline of 6% for the S&P 500.
Long-Term Investing In Income
To ease the volatility in the stock market, investors may want to add inflation-proof fixed-income investments to their portfolios, such as U.S. Treasury Inflation Protected Securities (TIPS). A good ETF is Schwab U.S. Tips (SCHP). The $22 billion fund provides supercheap exposure to the full spectrum of TIPS bonds, with an annual expense fee of just 0.05%. It was down 5.5% year-to-date through April 6. In 2021 it distributed $2.76 per share in dividends.
“TIPS compensate investors for rises in inflation,” said Kevin Harper, CIO at Almanack Investment Partners. “The 10-year market expectations for inflation are only marginally higher than they’ve been for the past 20 and 10 years. So the market is basically saying everything is going to go back to normal.”
If the Fed makes a mistake, “Investors should own inflation-linked bonds and consider them much more so than nominal, because these at least will compensate for unexpected inflation,” he said.
Short-term bonds also tend to keep pace with inflation. Keep in mind that rising inflation usually coincides with rising interest rates, which means lower bond prices. When rates are rising, newly issued bond yields are higher and more attractive to investors than existing bonds.
Dividend stocks also can provide a steady stream of income and they can appreciate in value. There’s been a shift among the top dividend payers. AT&T (T) had been the highest-paying dividend payer on the S&P Dividend Aristocrat index. But AT&T cut its annual dividend nearly in half on Feb. 4, making way for IBM (IBM), Exxon (XOM) and Chevron (CVX) to take over.
Check out the nearby list of top dividend payers with a Composite Rating of at least 75, ranked by YTD performance through April 6.
Value Vs. Growth Stocks
Value and growth stocks for decades fought a battle over which were the best investments. For 20 years through the Great Recession of 2007-09, value outperformed growth. Then growth stocks started to outperform. For the past 10 years, through Jan. 24, the Wilshire U.S. Large-Cap Growth Index vastly outperformed the Wilshire U.S. Large Cap Value Index, with a total return including reinvested dividends of 382% vs. 236%.
About a year ago, value stocks started to outperform growth again, with the Wilshire U.S. Large Cap Value Index gaining 18% vs. 9% for the Wilshire U.S. Large-Cap Growth Index for the year ended Jan. 24. Year to date through April 7, the S&P 500 Value ETF (IVE) has been flat, as compared with -10% for the S&P 500 Growth ETF (IVW). Much of that relative outperformance can be attributed to inflation. Value stocks tend to have stronger current cash flows that slow in growth over time, while growth stocks sometimes have little or no cash flow today but are expected to increase cash flow over time.
For the past decade, many investors haven’t even glanced at P-E ratios.
“All else being equal, the higher the level of inflation, the greater the discount rate applied to earnings and, therefore, the lower the price-to-earnings ratio investors are prepared to pay,” said Schroders’ Markowicz.
Value stocks “are finally having their day in the sun, and this might last a little longer this time as higher inflation and interest rates may persist,” Gaggar said.
Fidelity’s director of quantitative market strategy, Denise Chisholm, sees leadership shifting toward value stocks, and specifically energy and financials. She explained that if inflation remains above the historical average of 3%, “there’s much higher odds for financial stocks and much lower odds for technology stocks” to outperform.
So if you believe that we are entering a long-term inflationary environment, you may want to tilt a portion of your long-term investing portfolio to value stocks and value funds. You can find the best value ETFs of 2021 here, like iShares Core S&P 500 (IVV), Vanguard Value ETF (VTV) or one of the small-cap value ETFs such as Avantis U.S. Small Cap Value (AVUV).
Financial stocks can also be buffers to rising inflation. Banks stand to benefit from inflation as long as the Federal Reserve raises rates, which increases the interest that banks can charge when they make loans and boosts their bottom-line profits.
Financials, like most value stocks, stand to gain from above-average inflation. Financial stocks were the least expensive sector at the end of 2021 by price-to-earnings ratio. Nonetheless, financials have struggled recently as the yield curve has started to invert. A yield curve inversion is when the price of 10-year Treasuries falls below the rate on two-year Treasuries. Historically, economists have seen that as a sign that we could be entering a recession. Plus, banks borrow at the short end and make loans based on longer-term rates.
Or you can buy some of the individual stocks outperforming the market that we follow in IBD. Just take care to stay in step with the stocks currently leading the market. The IBD 50 list of the best stocks is filled with oil, health care, real estate and commodity stocks, such as CF Industries (CF), Matador Resources (MTDR), Regeneron Pharmaceuticals (REGN) and Rexford Industrial Realty (REXR).
Follow Michael Molinski on Twitter @IMmolinski
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