How Inflation and the Pandemic Could Affect Your Portfolio

Inflation is considered a feature of economic recovery.

15:34 20 August 2021

Inflation is considered a feature of economic recovery. In the United States inflation is being driven by overlapping factors from the COVID-19 pandemic and low interest rates set by the Federal Reserve. According to a CNBC report several rounds of direct government stimulus to consumers and businesses and pent-up consumer demand all have a role to play. 

 

With economies still recovering from the pandemic, there is much uncertainty about the future, and rising inflation rates do not paint a positive picture. As inflation rates rise, this may be beneficial for your portfolio, but this is not guaranteed. This article will explain the possible effects of inflation and how to make sure your portfolio survives it unscathed.

 

Is inflation good or bad for stocks and bonds?

Gradual inflation has shown that stocks and bonds still produce decent returns as long as the inflation does not come in big waves. When inflation has stayed consistent, stock returns have proven to be between 11% and 15% annually, including dividends. Contrastingly, bond prices may drop if interest rates surge. 

 

The inflation rate almost doubled in only two months

The March inflation rate reading was 2.6%, and that reading read 5% in May. The drastic jump that was observed would normally be a great cause of concern and would have the Federal Reserve intervene, but this has not happened at this point. 

 

The Federal Reserve has not taken any steps to fight inflation because it blames it on supply constraints and bottlenecks related to the pandemic. Because pandemic’s are not permanent, the Federal Reserve believes that the inflation too is only temporary and does not need any intervention. A wait-and-see approach has been put in place before and intervention takes place. 

 

This, which at first may not seem as the best approach, may be the best approach because even though the economy is recovering it may still be too fragile to successfully survive interest rate hikes. Although this may be a justifiably smart decision at this point, there are concerns that the situation will mirror the mistake the Federal Reserve made in the 1970’s. In the 1970’s, there were large budget deficits, wage and price controls and the US dollar had recently left the gold standard. 

 

The Federal Reserve misjudged how loose it could run a monetary policy and this caused an uncontrollable rise in prices which led the Federal Reserve to aggressively raise interest rates. This led to a drop in inflation, but in turn caused two recessions. The circumstances are different now than in the 1970’s where the economies are still running, but this possible reliving of past mistakes has been raised as a concern.

 

The stock markets are rising

Although there has been an increase in inflation, the stock markets have kept rising since March. This could partly be because investors, like the Federal Reserve, also believe that the inflation is temporary. But it should be noted that inflation has proven to be positive for stock markets in certain situations seeing that higher inflation means high revenues. If the higher revenues are able to grow greater than expenses, a greater profit is generated. But, even if this is the case, too much of a good thing is never good. The bond market, contrastingly, has not reaped the benefits of inflation. Bond prices fall when interest rates rise. 

 

Understanding your portfolio is vital

To avoid inflation, it is imperative to understand the investments you own in your portfolio. Knowing the ratio between your stocks and bonds is important seeing that this is a clear indicator of future returns, but it is also important to know the specific types of investments you own. Regarding stocks, you would need to know whether your stocks are sensitive towards interest rate changes or not. Regarding bonds, you would need to know the maturity and credit worthiness of the bond holdings in your portfolio. If you own bond investments with shorter maturities, you are in luck because these types of bonds are less sensitive to changes in interest rates. If your bond has a lower duration they are also less sensitive to interest rate changes. 

 

How does your portfolio survive a rise in inflation?

To protect your portfolio you would need to focus on credit risk within fixed income, you would need to rotate toward areas of the equity market that benefit from reflation, you would need to increase allocations to real assets and you should consider how asset classes work together and be prepared for different risks.