By: A.J. Fusco and Sam Shikiar, CFA
The price of nearly every consumer good is up, and the dollar is worth less than a few months ago. We are in a time of significant inflation. We feel the impact in everyday purchases, but should we be thinking about our investments and inflation’s impact on them? To help answer this question our friends A.J. Fusco and Sam Shikiar, CFA, of Shikiar Asset Management in New York City, offer guidance on working with investments through these tough economic times.
Many articles have been written about inflation over the past several months. It’s important to our daily lives, but also affects the investing landscape. In this article, we share our thoughts and observations, as well as key questions to consider for your personal asset allocation and investments.
Inflation in the U.S., as measured by the Consumer Price Index (CPI), is at its highest level since 1982. A surge of fiscal stimulus following COVID-19 resulted in an exceptionally accommodative monetary policy. This, coupled with strong consumer demand and supply chain bottlenecks has created price spikes in areas such as food, cars, rent, and energy. In the following chart, we see that inflation is broad-based, with prices rising in every reported category year over year.
CPI is weighted by certain measures of importance, with rent accounting for over 30% of increase year over year. The common initial impression was that inflation appeared to be “transitory” and would revert to the mean, but many components of inflation are now being perceived as more persistent. The release of the January 2022 CPI on February 10th made this more apparent with a 7.5% year-over-year increase on a headline basis. This result shows that inflation is continuing to accelerate from already historic highs.
12-Month Percent Change in Consumer Price Index (December 2020 to December 2021)
Source: U.S. Bureau of Labor Statistics
Let’s dive deeper into the actual effects of inflation on investments. For starters, inflation means that each dollar can purchase fewer goods and services than it did in the past (a decrease in purchasing power). Another important concept to grasp is the premise of “real yields” (interest rates), which are calculated by subtracting the rate of inflation from an asset’s nominal (stated) interest rate. For example, if a bond has a current annual yield of 2% but inflation is 5%, the owner of the bond will experience a decrease in purchasing power (real yield) of -3%. At today’s level of inflation, many bond investors are currently experiencing negative real yields. For investors who hold cash, where nominal returns are near 0%, the result would also be earning a negative real yield as inflation erodes overall value as measured by purchasing power. Lastly, there has been a major selloff in high-growth (but often not-yet profitable) stocks based on the anticipated increase in U.S. interest rates, among other factors. Higher interest rates are typically viewed as a headwind for such growth stocks – more on this later.
So where is one to turn in such an investment environment? Considering the returns in cash and bonds, investors may consider turning to certain equities as an option to out-return inflation. The below chart shows possible annualized real returns in each asset class for the next 5-10 years. Sustained inflation has driven down forecasts for fixed-income assets, implying equities may very well return a premium to other various asset classes in the medium term.
Source: AQR Capital Markets
Cyclical stocks, such as energy, financials, and other commodity-linked companies, might benefit from rising prices. As seen in the latest market rotation, history suggests that value stocks tend to outperform growth companies in inflationary environments. In the early trading days of 2022, the market observed a significant rotation from growth to value, driving many technology stocks to their lowest levels in the past 18 months. In terms of companies to consider investing in, pricing power may be key. As a result of supply chains and inflationary pressures, input costs are at all-time highs. Companies that can pass those costs on to consumers, without negatively impacting demand, find themselves in a better position than those who cannot. Sectors such as materials and consumer discretionary, which have inelastic prices (demand is not affected when prices rise) could potentially offer superior returns in the current operating environment as well. Lastly, “real assets” such as commodities (metals, agriculture, energy, etc.) and real estate may be viewed as safe havens during inflationary environments.
Our discussion shows there are no shortages of challenges in the current market environment. However, investors who are patient, remain invested, and have a longer-term investment horizon may benefit.
Key questions and areas to discuss with your financial advisor include the following:
- What kinds of fixed-income instruments do I hold in my portfolio? How would a rise in interest rates likely impact the value of my fixed-income portfolio?
Investors should consider the maturity date of their bonds. Shorter term bonds can be viewed more favorably as the investor can seek to participate in higher rates earlier than those who are locked into a longer-term maturity bond today.
- What is my balance of value versus growth equities?
Investors should monitor what percentage of their portfolio is allocated to value sectors (energy, industrials, and financials) vs. growth sectors (technology, e-commerce and fintech)
- How much cash am I currently holding and is this cash yielding any income?
Investors should consider how much cash they are currently holding, the real after-inflation yield of holding cash, and where they could better allocate that capital. One should also evaluate the type of vehicle cash is held in such as money market funds, CDs, etc. and understand the yields being earned on those holdings. Investors should also understand the savings rate they are earning within their checking, savings, brokerage, and retirement accounts and evaluate if those vehicles are offering a reasonable return in this inflationary environment.
- Do I have any direct or indirect exposure to “real assets” such as commodities and real estate?
Investors should evaluate their exposure to REITs, real asset/commodities ETFs, gold, and private investments as these may be a potential shelter for inflation.
- What is my exposure to floating-rate securities, which may offer higher yields in a rising interest rate environment?
Investors should understand the nature of the securities they hold. What interest rate are they tied to, how often is the yield on their investment adjusted and the nature of their exposure.
- How would my mortgage and credit card payments be impacted in a rising rate environment?
Investors should understand the nature of their mortgage and whether it is fixed or floating rate. There may be opportunities to refinance, lock in, or adjust rates to decrease potential future payments. Investors should do the same exercise with credit card rates as well.
These are some of the conversations that we are having with our clients. In terms of the U.S. equity markets, we anticipate and expect periodic corrections such as what has recently been witnessed. When these occur, our experienced investment team remains nimble but will also keep “a steady hand on the tiller.”
We believe that in this environment more than ever, an unwavering commitment to proprietary research as well as an extremely stringent investment selection process is critical. We further believe that thoughtfully constructed portfolios with growth and dividend-paying stocks, higher yielding common and preferred equities as well as corporate, municipal and Treasury debt can “weather the storm.” We continue to seek portfolio companies that manifest attractive, sustainable long-term fundamentals that encompass the following: leading market share, strong balance sheets, free cash flow, revenue and earnings growth, cash dividends, share repurchases, and well-respected managements. We remain steadfastly focused on achieving investment objectives – preservation of capital coupled with a performance goal of comfortably exceeding the risk-free rate of return plus inflation and we remain confident in realizing this investment objective over a complete market cycle.
Thank you A.J. and Sam for this insightful look at managing investments in a high-inflation environment. Remember, this blog is an overview and many specifics of your portfolio and your tolerance for risk must be considered by you and your financial advisors before employing changes. The Tax Warriors® at Drucker & Scaccetti are often part of a team of trusted advisors for clients; each having our client’s financial peace of mind as a top priority. We’d be happy to work with you and your wealth manager to help you achieve your goals.
You can contact the author of today’s blog, Sam Shikiar, here.
Shikiar Asset Management, Inc. (SAM) is an investment advisor registered with the Securities and Exchange Commission under the Investment Advisors Act of 1940.
All information contained herein is for informational purposes only, not for trading or investing purposes. The information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. SAM is not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information. Please refer to SAM’s Form ADV for additional information and risks. There is no assurance that SAM’s investment strategies will produce profitable returns. Past results are not a guarantee of future results and no representation is made that a client will or is likely to achieve results that are similar to those shown or discussed.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
All investments involve risk, including loss of principal. Past performance does not guarantee future results. There is no assurance that the investment process will consistently lead to successful investing. Asset allocation and diversification do not eliminate the risk of experiencing investment losses.