As investors wait for inflation to settle down, diversification and rebalancing provide better protection than market timing. We explore the economic threats that make this protection necessary.
Inflation has turned into a harder beast to tame than many of us anticipated just 12 months ago. Not only are prices continuing to remain high, but there’s a real potential for above-target inflation persisting for the next few years. This outcome is possible in spite of Federal Reserve chair Jerome Powell’s recent warning that he's willing to accept slower growth and higher unemployment, if that’s what it takes to achieve price stability. At their meeting last month in Jackson Hole, Wyoming, central bankers from around the world agreed that interest rates might have to rise further and remain high for longer for just that reason.
Increasing government debt loads, worker shortages, a slow and choppy transition to renewable energy, and continued geopolitical tension may counterbalance the central bank’s ability to course-correct inflation back to its 2% target. Investors need to consider the very real possibility that inflation may remain a concern for the next several years. They can take steps today to protect their portfolios from this new inflation reality. Let’s look at some of them.
Inflation fighter #1: Boosting diversification
A key challenge that inflation poses to investors is its effect on the correlation between stock and bond prices, a fundamental determinant of risk for the traditional balanced portfolio. When economic growth drives asset prices, stock and bond returns tend to diverge from one another, allowing investors to take the traditional approach of relying on stocks for growth and bonds for income and diversification benefits. But when inflation drives asset prices, stock and bond returns tend to move in tandem.
Low levels of inflation coupled with episodic periods of growth have resulted in stock–bond correlations hovering near -0.5 for most of the last two decades. This outcome produced a high level of diversification benefits and thus lower risk for a traditional portfolio. The asset class relationship changed in the first half of 2022: The S&P 500® dropped 20.6%, while the Bloomberg Treasury Index was off 9.1%. We witnessed similar changes to the stock-bond relationship during inflationary periods throughout the latter half of the 20th century.
Twelve-month stock-bond correlation, 1970–2021
Source: Morningstar Direct, 9/2/2022. For illustrative purposes only. Not a recommendation to buy or sell any security.
Twelve-month stock-bond correlation, 2000–2022
Source: Bloomberg, Barclays, 9/1/2022. For illustrative purposes only. Not a recommendation to buy or sell any security.
Investors could consider other asset classes as a way to gain further diversification for the traditional portfolio and protection from inflation. For example, an allocation to a broad basket of commodities has historically provided strong protection against above-consensus inflation and diversification versus stock and bonds. Commodity returns are especially sensitive to the Consumer Price Index (CPI)—the inflation measure that attracts the most attention—driven largely by demand for raw materials and food and energy consumption. A 5% commodity allocation can offer significant protection to a broader portfolio dominated by equity and bond risk. In the first half of 2022, while more traditional asset classes came under pressure, the Bloomberg Commodity Index went up 18.4%.