Today’s investors have grown used to operating in a deflationary world with an expanding economy. We haven’t seen serious inflation since the 1980s, but that could be about to change.
COVID-19 has hit markets hard, bringing demand shock as sudden unemployment, uncertainty, and lockdowns prevented people from making purchases, but also breaking supply chains as factories shut down and demand started getting erratic, depending on the sales channel and product category. Although May and June saw manufacturing levels rise, output was still 11.1% below its level in February 2020.
And all the while, the global economy has shrunk more than twice as much as it did during the 2008 recession.
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Amidst significant uncertainty about the future of the markets, there’s general expectation that deflation cannot last. Broken supply chains and uncertainty around logistics force retailers to raise prices for basics like groceries. Airlines, restaurants, and hospitality companies are operating at reduced capacity, and in-person service providers need to slow down their stream of clients to allow for increased safety regulations.
As the costs of operating safely continue to mount, businesses that are struggling to stay afloat will have no choice but to raise their prices.
COVID-19 also seems to have triggered a shift away from the recent globalized model and “just in time” inventory management. Companies are realizing the vulnerability of global supply chains, leading many to swap low prices for increased stability of supply, provoking price rises. At the same time, trade wars between the US and China could bring an end to cheap, mass-produced goods from Asia.
Central banks acted fast in response to the contracting economy and rising unemployment, but events are rapidly spiralling out of their control, and their policies could be making things worse. QE policies increase the chances of inflation as liquidity swamps the markets.
Maleeha Bengali, CEO of MB Commodities Capital, points out that printing money is easy, while fabricating jobs out of thin air is impossible. “This is something the Fed is unable to control, it cannot print jobs. But their thinking is that enough money will solve the problem,” he writes. “What this does create is too much liquidity in the system, leading to inflation. We all know inflation is a matter of when not if, especially given the unprecedented amount of QE done by the Fed.”
Other economic analysts are predicting a stagflation, with the drastic slash in demand for consumer goods as shoppers hold onto their cash combining with a contracting economy forcing up prices.
Atlanta-based economic commentator Kevin Mercadante, for one, is adamant that investors need to prepare for an extended period of inflation. “Any steps you can take to prepare in advance will pay off handsomely, especially over the long term,” he writes. “This is especially true because inflation has been low or declining for at least the past three decades. But if there's a change in direction, it can be quite dramatic.”
Assuming, then, that inflation is inevitable, what are savvy investors to do? Here are some pointers for taking swift action to protect your portfolio.
Look for Alternatives to Bonds
Government bonds are already close to record lows, making them a poor option for decent future returns. There’s even a chance that financial repression could bring negative returns on government bonds. Inflation usually drives equities up, but this time it’s combined with weak growth, which often prompts equities to underperform.
“Higher inflation not only reduces the real return on bonds but potentially reduces the diversification benefit of holding bonds in a portfolio with equities.” says Alan Dunne, managing director of Abbey Capital. “Investors are therefore left with the challenge of finding alternatives for government bonds, ideally with a low or negative correlation to equities and protection against possible inflation.”
Many investors recommend putting money in TIPS or other money market funds, which are interest-bearing investments that perform well during inflation, even though the real yields on TIPS are down at the moment.
Real Estate Is Stable – Usually
During inflation, real estate is generally a safe investment. It’s a true hard asset that doesn’t lose its value during inflation. In fact, real estate values often rise in periods of inflation, because increases in rents drive more people to buy.
However, you still need to exercise caution when you choose where to invest. Shopping malls, student accommodation, and hotels are traditionally seen as safe real estate investments, but the pandemic has made all of them shaky and uncertain.
Even commercial real estate has its ups and downs, with so many offices disbanding in favor of remote work models. You’ll do better investing in warehousing for logistics and ecommerce distribution; multi-family housing, which tends to remain steady; or farmland or timberland, which are typically stable.
Develop a Creative Mix in Stock Holdings
High dividend-paying stocks are a popular choice to balance out equity or bond portfolios, but they too are negatively impacted by rising inflation, so the traditional 60/40 mix of stocks and bonds isn’t looking good at the moment either.
Inflation will undercut the returns on stocks without bringing a corresponding rise for government bonds.
That said, there’s a place for careful investing in stocks in certain sectors, which almost always rise in an inflationary market. Energy, healthcare, food, and commodities like gold and precious metals rarely drop during inflation, so they can play the role of bonds by delivering steady growth.
Accepting What the Future Gives You
There’s no denying that COVID-19 is impacting more than our physical health; our financial and economic health have also been severely harmed. Inflation is on the horizon, but lulled by decades of deflation, investors may not react quickly enough. With uncertainty all around, it’s clear that savvy investors need to prepare their portfolios for inflation by investing in alternatives to traditional equities and bonds, considering real estate, and replacing high-yield stocks with high-growth sectors that stand up well to inflation.