Market volatility and inflation can both be effective at destroying investment value. Here’s how investors can account for both in their long-term portfolio strategy.
The daily financial media word “salad bar” features a couple of terms that tend to grab investor attention: inflation and volatility. Both phenomena are always around to some degree, but each is very different from the other. Prudent investors must account for both in their long-term portfolio strategy without overcompensating on one side or another.
A spike higher in volatility can indeed be spooky, and investors need to prepare for such events. But you know what’s really scary? Inflation can chew away long-term value and returns in a portfolio that’s too “safe” or overweighted in stable but low-yielding assets that can’t keep up with inflation, even a modestly higher rate of inflation.
It’s understandable for long-term investors to seek ways to protect against market turmoil and greater volatility through safe-haven assets such as Treasuries, according to Viraj Desai, senior manager, Portfolio Construction, at TD Ameritrade Investment Management, LLC. But it’s also important to consider the potential implications of higher inflation as the economy rebounds from the COVID-19 pandemic.
“Lately, it seems portfolio diversification is acting in ways that typically get less attention. Equities are ‘working’ as the stock market climbs, but bonds are not, given prospects for an inflation uptick,” Desai explained. “But a sound diversification strategy should be reviewed regularly and factor in changing market and economic dynamics, especially considering what’s happened over the past year.”
What can investors do? Well, asset allocation and diversification can not eliminate the risk of experiencing investment losses. And there’s no such thing as a portfolio strategy that’s 100% inflation-proof and 100% volatility-proof. But investors can consider a few steps that attempt to balance efforts to gird against both inflation and volatility. Here are four ideas to consider.
Concerns over higher inflation have escalated as the economy’s recovery spurs demand for goods and services and sparks rallies in prices for crude oil, copper, and other commodities. In May 2021 the U.S. Consumer Price Index (CPI), a widely followed inflation benchmark, surged higher than expected, 5% from the same month in 2020, and was the largest year-over-year increase since 2008.
“Headline” numbers like that might raise eyebrows, especially considering how we’ve become accustomed to inflation in the 1% to 2% range for years. But that’s not necessarily a good reason to unload all your bonds.
“Depending on your risk-tolerance, bonds might be in your portfolio prescriptively because your tolerance for risk is very low,” Desai said. “And remember, while equities have rallied, they still carry a lot of risk relative to bonds.”
One possible solution: “You could reduce the ‘duration’ of your portfolio by moving from long-term bonds to short-term bonds,” Desai suggested. “By doing so, you still have an anchor against volatility, but you’re not exposed to the more pronounced rise and fall of interest rates that are experienced on the longer end of the yield curve.”
Government-backed debt like 10-year Treasury notes (which yielded about 1.5% in mid-June 2021) are about as solid as they come. Although it must be pointed out that the government guarantee only applies to the repayment of principal and interest on bonds held to maturity. Like all bonds, Treasuries are subject to price risk—they typically typically decrease in value as interest rates rise and rise in value when interest rates fall. So, if you need to sell a bond prior to maturity, depending on the prevailing interest rate at that time, you might be selling at a loss.
That being said, there are other debt vehicles or “credits” that can provide similar stability and a buffer against rising inflation. Such assets can “give you a little bit more of a lift from a coupon perspective and, in many cases, can help you incrementally to ‘clip’ a coupon at or above the rate of inflation,” Desai said.
In another example, Treasury Inflation-Protected Securities (TIPS) are a special type of Treasury bond indexed to inflation, meaning its principal amount is adjusted higher by the inflation rate each year. This offers some built-in protection from inflation. In theory, this means the purchasing power of the income received from a TIPS investment is largely protected against inflation. But if interest rates rise in a low- or no-inflation environment, the TIPS’ price could decline.
Investors can invest in TIPS directly or through mutual funds and exchange-traded funds that hold TIPS.
Alternative investments include commodities, managed futures funds, “absolute-return” funds, private equity, and other vehicles designed to be uncorrelated, or minimally correlated, with stocks and bonds. In theory, that means that when stocks in your portfolio move one direction, alternative investments move the other way.
Alternatives can help diversify your portfolio and add a potential buffer against market turmoil or an inflation spike, but these assets may also pose a greater risk. Absolute return funds, for example, “at times can behave like bonds given their lower betas to equities, but they carry more volatility and are subject to higher tail risk than bonds,” Desai pointed out.
Commodities such as oil, gold, and soybeans can be viewed as a means to protect against or even capitalize on inflation, but they also can be volatile, and individual commodities have specific supply-demand dynamics that could cause them to underperform or be a poor inflation hedge. Desai suggested that investors carefully study how commodity markets work and understand the risks before jumping in.
A 5% surge in CPI might be eye-opening, but such numbers are not unusual when the economy is emerging from a sharp economic downturn like we had in early 2020. “Such increases tend to smooth out over time,” Desai noted.
“What investors should keep in mind is it’s not necessarily the level of the CPI monthly ‘print,’ or headline figure; it’s the fundamentals that contribute to CPI increases or decreases,” Desai said. “If you look at past recoveries, typically a recovery in growth is often associated with some pickup in inflation over the short run. Part of that is ‘base effect’ because inflation often recedes in a recession, and as the economy recovers, you see higher inflation readings simply because year-on-year front end is very low.”
The so-called base effect is one of three dynamics driving the economy and markets at the moment, along with “reflation” of the economy and pandemic-related supply and demand imbalances, and all three are pushing inflation higher over the short run. Many of these factors are likely to right-size themselves in the months ahead, and supply-demand imbalances due to COVID-19 won’t last forever.
That leads to a key point for investors: Inflation, volatility, and interest rates are among countless factors and wild cards that can come into play and are outside an individual’s control. That said, investors might consider looking at their portfolio strategy like they would their house: something that’s built to last all seasons, from sunny days to stormy nights.
“As an investor, understand it’s not just the downmarkets where part of your portfolio is going to ‘work’ and a part is not. The same principle applies in upmarkets, which makes it critical to be flexible and prepared to make adjustments if needed,” Desai explained. “This way, you create sort of an ‘all-weather’ feature for your portfolio, where in an upmarket, the equities are being put to work and in a downmarket, the bonds are protecting you from incrementally higher volatility.”
TD Ameritrade can help you find investments aimed to mitigate market volatility.
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