Keep Calm and Be Vigilant About Inflation

Investment firms signal that inflation, near-term, will be transient rather than persistent. But investors need to be watchful.
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Many investment firm pundits are today publishing white papers proclaiming that inflation is poised to pick up for a variety of reasons and what investors should do when the cost of goods and services starts to rise.

Consider: In a recent report, Gargi Pal Chaudhuri, head of iShares Investment Strategy Americas at BlackRock, laid out four factors that could support an inflationary backdrop in 2021:

1. Monetary policy -- the Federal Reserve is willing to tolerate higher inflation.

2. Fiscal stimulus -- With President Biden signing an additional $1.9 trillion fiscal relief package, the total fiscal stimulus efforts provided in the wake of COVID-19 is about double the pandemic-inflicted loss in gross domestic product and is close to 25% of 2020 GDP. President Joe Biden’s $2 trillion plan to rebuild the infrastructure is also part of the fiscal stimulus that could lead to higher inflation.

3. Pent-up demand – As economies open and more of the U.S. population is vaccinated, Chaudhuri expects to see a surge in spending as some of the “pent-up demand” is unleashed.

4. Rising production costs -- As companies rethink their supply chains and seek out ways to eliminate or reduce supply chain concentration in one region of the globe, production costs could move higher as industries consider more than just the lowest-cost options.

To be fair, Chaudhuri noted in her report that while inflation should pick up from its current run rate of 1.3%, she sees little fear of runaway inflation due to structural issues such as an aging population and the disinflationary impact of technology.

Others investment firms share this point of view. “Near term, inflation will be transient rather than persistent,” wrote Anwiti Bahuguna, a senior portfolio manager at Columbia Threadneedle Investments. “But this doesn’t mean the pressures will be any less real for markets and investors as the economy recovers. Longer term, the Fed’s new mandate, which implies they will be more tolerant of inflation, could help smooth the economic ride and settle the market’s nerves. Only time — and the data — will tell if it does. Until then, keep an eye on inflation, but don’t let it dominate your view.”

Since inflation tends to rise in tandem with economic growth, however, Chaudhuri noted in her report that certain parts of the equity market, commodities and bond markets can help hedge portfolios for the upcoming rise in inflation.

Fixed Income

“Investors might focus on bonds that are designed to pay more as inflation increases, namely Treasury Inflation-Protected Securities,” Chaudhuri wrote. “Additionally, floating-rate fixed income products have tended to perform well as rates increase, or consider short-duration government bonds, which have tended to be less sensitive than long-duration bonds to rising interest rates.”

Other firms are also weighing on the challenges of a low but rising interest rate environment for bonds. According to a report published by Tim Murray, a capital markets strategist at T. Rowe Price, investors could consider increasing their allocation to higher-yielding corporate bonds. “High yield bonds should offer higher income, currently, and are also less sensitive to rising rates,” he wrote, noting that the primary downside to high yield bonds is their higher credit or default risk, especially during times of economic stress, relative to investment-grade bonds. “While this is a valid concern, the current environment appears favorable for credit risk for the same reason that interest rates are rising — i.e., improving economic growth expectations.”

Equities

“Investors might focus on sectors of the market that may benefit from a rising-yield environment and a steeper yield curve,” Chaudhuri wrote. “Financial companies have tended to benefit from the difference between what a bank pays to get deposits (short-term rates) and what it charges to lend money (long-term rates). We also believe economically sensitive small-cap U.S. stocks, as well as “value” stocks, could be poised for gains.”

Commodities

“Commodities including energy, metals and agriculture have been among the strongest-performing assets of 2021, and we think there is room for more demand based on accelerating global growth, tight inventories and supply chain shifts that favor localized production,” Chaudhuri wrote.