As the U.S. economy recovers, we are increasingly cognizant of the notion that higher inflation may potentially surface. In fact, the seeds of future inflation reside within the U.S. Federal Reserve’s extraordinary efforts over the past six years to revive the economy from the depths of the Great Recession. The adoption of unconventional monetary policies has led to a 48 percent increase in the money supply through a nearly five-fold increase in the Fed’s balance sheet. Recent improvements in economic data have allowed the Fed to “taper” and eventually reverse its easy monetary policy approach, but the potential inflationary forces it created remain in the financial system.
Therefore, investors may want to explore ways to dampen the potential impact of rising inflation through a few portfolio adjustments.
Therefore, investors may want to explore ways to dampen the potential impact of rising inflation through a few portfolio adjustments.
First, consider bonds: Since higher inflation closely correlates with higher interest rates, bond investors need to understand the implications of rising rates and adapt accordingly: Shortening the duration of your bond portfolio can lessen the price volatility associated with a movement in rates. Second, consider diversifying your holdings to include floating-rate corporate bonds. These securities earn a yield that includes both a spread reflecting credit risk and a floating-base rate, typically the London Interbank Offered Rate (LIBOR), which is reset on a regular basis. This frequent reset means these loans carry far less interest-rate risk than bonds that pay a fixed-interest rate.
Equities have historically been an effective asset class for investors concerned with rising inflation. For example, companies with low variable costs, but stable or increasing revenues, tend to perform well in an inflationary environment. Also, best-of-breed companies with dominant market share possess pricing power and the ability to pass along the higher input costs that oftentimes surface during periods of inflationary stress. Finally, active equity strategies are able to emphasize companies with the forementioned traits relative to a passive index.
Investors have traditionally used single solutions like commodities and Treasury inflation protected securities (TIPS) to hedge against inflation risks. However, their sensitivities to inflation sometimes vary, often creating more risk than investors anticipate. A risk-managed, multi-asset solution that invests across a broad range of inflation-sensitive asset classes is an appealing option. We believe expanding the universe of investment options that are highly sensitive to inflation delivers a more efficient portfolio.
Lastly, investors of all types should consider an allocation to hedge fund strategies, either through traditional hedge funds or “liquid alternative” mutual funds. Hedge fund strategies can help mitigate downside portfolio risk and often benefit from rising rates, making them an attractive enhancement to allocations. From January 2000 through September 2013, during months when the 10-year U.S. Treasury rates were rising, hedge funds exhibited positive returns in 58 of 78 months (74 percent). For specific strategies like fundamental equity long/ short, higher interest rates mean higher rebates on their short positions. For credit arbitrage managers, interesting relative-value opportunities can be more pronounced during periods of rising rates. For example, a manager might invest in floating-rate bank loans and hedge their credit exposure with duration-sensitive, fixed-rate corporate bonds.
While there is evidence to suggest that higher inflation may not be on the immediate horizon, the aggressive monetary steps taken over the past six years will likely have inflationary repercussions and investors can take steps now to address the impact this will have on their portfolios.
Chicago, IL Leading Wealth Advisor
Equities have historically been an effective asset class for investors concerned with rising inflation. For example, companies with low variable costs, but stable or increasing revenues, tend to perform well in an inflationary environment. Also, best-of-breed companies with dominant market share possess pricing power and the ability to pass along the higher input costs that oftentimes surface during periods of inflationary stress. Finally, active equity strategies are able to emphasize companies with the forementioned traits relative to a passive index.
Investors have traditionally used single solutions like commodities and Treasury inflation protected securities (TIPS) to hedge against inflation risks. However, their sensitivities to inflation sometimes vary, often creating more risk than investors anticipate. A risk-managed, multi-asset solution that invests across a broad range of inflation-sensitive asset classes is an appealing option. We believe expanding the universe of investment options that are highly sensitive to inflation delivers a more efficient portfolio.
Lastly, investors of all types should consider an allocation to hedge fund strategies, either through traditional hedge funds or “liquid alternative” mutual funds. Hedge fund strategies can help mitigate downside portfolio risk and often benefit from rising rates, making them an attractive enhancement to allocations. From January 2000 through September 2013, during months when the 10-year U.S. Treasury rates were rising, hedge funds exhibited positive returns in 58 of 78 months (74 percent). For specific strategies like fundamental equity long/ short, higher interest rates mean higher rebates on their short positions. For credit arbitrage managers, interesting relative-value opportunities can be more pronounced during periods of rising rates. For example, a manager might invest in floating-rate bank loans and hedge their credit exposure with duration-sensitive, fixed-rate corporate bonds.
While there is evidence to suggest that higher inflation may not be on the immediate horizon, the aggressive monetary steps taken over the past six years will likely have inflationary repercussions and investors can take steps now to address the impact this will have on their portfolios.
Chicago, IL Leading Wealth Advisor
