MARKET UPDATE

The tragic invasion of Ukraine adds yet another dimension to the recent economic turmoil.

Over the past five years, the economy has faced a variety of challenges, including a trade war, significant tax policy changes, a global pandemic, social/political discord, a severe but incredibly short recession, unprecedented government spending, and a stock market collapse followed by an historic rally. Up to now, financial markets have been amazingly resilient, generating unexpectedly high returns over the past five years.

Against this backdrop, inflation had been surprisingly muted and consistent, remaining in a narrow range around 2%. It was this constant that allowed the Federal Reserve (Fed) to maintain accommodative monetary policies, some of which originated in the great financial crisis of 2008, and to provide monetary support during the pandemic crisis.

For investors concerned with rising inflation and the international crisis, investing in stocks or stock mutual funds that focus on valuation and fundamentals has become much more important. Companies with solid business plans, cash flow, and dividends are again relevant rather than disruptive innovators, initial public offerings, or alternative investments such as cryptocurrencies. 

Nothing lasts forever

For many years there have been critics of the Fed who believed that easy money policies would eventually lead to an inflation problem when too much money chased too few goods. However, like the boy who cried wolf, these concerns never materialized – until now. 

The most recent Consumer Price Index (CPI), which is a commonly used gauge of inflation, was up 7.5% on an annualized basis, much of it due to supply chain issues. Now, war in Europe is causing commodity prices to soar and supply uncertainties to increase, magnifying concerns over inflation.  

The Ukrainian situation presents a new problem for the Fed due to the impact that severe financial sanctions may have on global payment systems, liquidity and, ultimately, the stability of financial markets. Consequently, the Fed will need to factor this new reality into its policy initiatives that were expected to begin in March.

In addition to increasing short-term interest rates, the Fed is also poised to not only discontinue its large bond buying program but may consider actually selling some bonds out of its massive $9 trillion portfolio. The goal is to raise interest rates in order to moderate excessive demand that is adding to inflationary pressure.

This relatively sharp monetary policy pivot, in response to building inflationary pressures, has led to significant volatility and declines in the stock and bond markets. It has also added to the underlying anxious environment that has prevailed since the pandemic began.

Investing in an inflationary environment

Traditionally, when the Fed pursues tightening policy measures, the economy tends to slow and, oftentimes, eventually declines into recession. Bond prices typically decline (with rising interest rates) and stock prices may sometimes falter. Investment decisions are thus more challenging. However, some of the conventional thoughts on investing when inflation is moving up may provide only minimal benefits.

Conventional approaches to defending a portfolio from inflation typically focus on commodities (especially gold), Treasury Inflation Protected Securities (TIPS), and real estate. Although these may have a place in a well-diversified portfolio, excessively reallocating a portfolio to these areas can detract from long term wealth accumulation: 

• Commodities. Although commodity prices have surged during the pandemic and are now spiking after the Ukrainian invasion, they have been a poor asset class for long term investment. However, a modest allocation in anticipation of protracted inflationary environments can provide diversification and a modest hedge against inflation. Unfortunately, many investors react to commodity prices that have already surged, and thus tend to buy when prices are at the high point of their trading cycles. 
• Gold. For centuries gold has been considered a reliable store of value, and during this recent surge in inflation, it is up about 11% over the past year, with half of that gain since the beginning of the year in reaction to the invasion of Ukraine. But gold suffers from many of the same issues as commodities and can go through prolonged periods of being a dead asset.  
• TIPS. TIPS are structured such that the principal value of these fixed income securities goes up commensurately with inflation, as measured by the CPI. They provide some modest advantage over traditional bonds during a spike in inflation. Year to date, however, they are down about 1.5% because they still can suffer when interest rates move up rapidly. For individual investors TIPS can also be complicated to access, can be illiquid and can add tax complexities if held in non-qualified accounts. One area that may be appealing for individuals is I Savings Bonds, which are designed to protect investors from inflation, but investment is limited to $10,000 in a given year. 
• Real Estate Investment Trusts (REITs). Real estate has intuitively been a favored investment alternative during periods of rising inflation. However, like commodities, real estate is not a homogenous asset class, ranging from office, retail, and storage properties to farmland. REITS can suffer more from rising interest rates than they can benefit from rising inflation. Finally, it should be kept in mind that individual investors who own their own home already have significant exposure to real estate. 

What about stocks?

Worries over inflation typically lead investors to consider the “alternative” investment areas of commodities, gold, TIPS, and real estate.  But common stocks, which represent the core asset class for most investors, have historically generated reasonable long-term returns, relative to these alternative areas, even in an inflationary environment. Over longer periods of time, common stocks have typically generated meaningfully higher returns than most inflation hedging “alternative” assets. 

However, an inflationary environment provides unique challenges for corporate management teams to generate returns for shareholders. Managing costs, efficiently allocating capital, and astutely managing balance sheets becomes paramount. Companies that demonstrate these virtuous characteristics, regardless of capitalization size, have recently been performing well relative to the overall market.

Reacting to rising inflation…or not

It has been decades since inflation was truly a problem for the U.S. economy. The tragic events in Ukraine also may add to the potential for inflationary pressures to persist. However, some of the conventional alternative asset classes that are thought to provide meaningful protection against inflation may not provide enough of an advantage to warrant dramatically altering a portfolio.

Markets on average have historically recovered relatively quickly from geopolitical events such as armed conflicts and politics. The odds are stacked against most investors being nimble enough to execute tactics in their overall portfolios to take advantage of such short-term market action.

 A well-diversified portfolio certainly can include gold, TIPS, and REITs, as well as other assets that may marginally perform better in a more inflationary or crisis-oriented environment. But making significant allocations to these areas at the expense of core equities in hopes of gaining significant protection from inflation or geopolitical turmoil is likely to result in diminished long-term performance. It may be helpful to consult with your financial professional before making any changes in your portfolio.