Investors, historically, are constantly worried about geopolitical uncertainty, macro environment risks or pandemics. With inflation at the highest levels since 1982, these concerns take on increased validity due to the real consequences the economy is facing, as companies must pay more for employees and raw materials.
Ultimately, elevated inflation will tip the hand of the Federal Reserve as one of its mandates is keeping inflation at a stable level. In our view, we expect inflation to be elevated for the remainder of the year but see a path for price growth to decelerate over the summer. Investors are rightfully concerned about the impact this will have on their portfolios. The question to ask yourself is how do you safeguard clients' portfolios while the Federal Reserve combats inflation by increasing interest rates?
One of the more straightforward ways to protect against inflation is with Treasury Inflation-Protected Securities (TIPS), which are a type of U.S. Treasury security whose principal value is indexed to the rate of inflation. Essentially, when inflation increases, the TIPS’ principal value is adjusted up, but if there is deflation then the principal value is adjusted lower. While TIPS have fixed coupon rates, their coupon payment varies depending on their principal value and the change in the rate of inflation. It is important to note that TIPS are considerably more volatile than cash, especially during market corrections. While TIPS are worth considering as an inflation hedge, there is a risk they could underperform traditional U.S. Treasurys if the actual inflation does not meet the lofty expectations. Inflation-resistant fixed income investments include TIPS, shorter duration bonds, high-yield bonds and international bonds.
Today, dividends matter more than ever. The value side of the market is finally garnering attention from investors as they are beginning to focus on companies that have been overlooked for the better part of the past decade. These fundamentally valued companies appear quite compelling due to their pricing power, relatively inexpensive price point and potentially robust dividend payouts. Keep in mind that since 1930 dividends have accounted for roughly 40% of the overall return for the stock market. During periods of high inflation, companies that can increase their dividends will not only outperform the broader market but also reduce the volatility of a stock’s total return. Dividends can be reinvested throughout the year; thus, allowing investors to take advantage of price declines in the stock. During challenging times, these fundamentally valued companies provide investors with reassurance and peace of mind, since their profitability and ability to generate excess free cash flow will remain intact. Ideally, you want to invest in a company before the dividend growth is priced in. We expect companies that cut their dividends in 2020 to reinitiate and increase them as the economy and their businesses recover.
Inflation is always important from a financial planning standpoint because we need to take into consideration clients' long-term financial objectives relative to their purchasing power. Ultimately, the higher the rate of inflation, the higher clients' return will need to be to maintain the purchasing power of their assets. Staying ahead of inflation is a key component of investing and financial planning. The best way to achieve this objective is with a balanced portfolio that is diversified across asset classes and contains inflation-resistant investments. This will not only enhance client return but also reduce the overall risk and volatility of the portfolio.
John Harris is managing director, and Michael Unger is vice president, both at Coral Gables Trust Company.