How to Inflation-Proof Portfolios

Hefty price tags may be here to stay. The post-vaccine economy experienced what was billed as “transitory” inflation fueled by the “base effects” of comparing it to a time when the economy was shut down. However, as the year progressed, inflation remained elevated and price increases broadened across a larger swath of the economy. This development prompted Oppenheimer Asset Management (OAM) to publish timely commentary in 2021 called Navigating Inflation Uncertainty. The commentary pointed out that inflation may prove to be more persistent than initially expected and how to offset its ill effects. (If you're a client and want to read this piece, you can log in and click on the Research tab.)

In early 2022, it has become abundantly clear that high inflation is not transitory and will be a major obstacle for consumers and investors. The consumer price index (CPI) rose by 8.5% year-over-year in March, the largest increase since 1982. Energy prices have soared in recent months, an issue exacerbated by Russia’s invasion of Ukraine and the subsequent fallout for global supply. The Ukraine invasion also led to price spikes for other commodities that have contributed to higher food and input costs. Even before the invasion, the economy was dealing with supply chain disruptions stemming from the pandemic that drove prices higher. Supply chain pressure is likely to continue given China’s “zero Covid” policy and the related lockdowns that have halted production in parts of the country.

While prices in certain commodities are likely to soften from extreme levels today, inflation is now expected to persist well above the Fed’s target for the foreseeable future. Economists have been raising their inflation targets for 2022, and those projections increased notably after the war broke out. Market expectations for future inflation have also risen dramatically.

Heating Up, Cooling Down

A look at inflation expectations for the next two years shows consumer prices should continue to rise this year and then start to normalize in 2023 as the market digests Fed policy actions.

We highlighted a number of adjustments designed to protect portfolios from higher inflation. Given the current macro and inflationary backdrop, here’s how those recommendations fared over the last six months and whether they are still appropriate:

Result

U.S. value equities outperformed their growth counterparts. The year-to-date dispersion was particularly pronounced, as growth stocks sold off sharply to start 2022 while interest rates spiked. Value stocks were resilient in the face of higher rates and finished the first quarter flat. Cyclical sectors, particularly energy, outperformed as commodity prices rose.

Outlook

Growth stocks are still expected to face headwinds as the Fed aggressively hikes interest rates in an attempt to get inflation under control. However, inflation and geopolitical events could disrupt economic growth forecasted to be well above trend this year. The bond market is sending an ominous signal as the Treasury yield curve has recently inverted, historically serving as a precursor to recessions. If persistent inflation leads to a meaningful slowdown in economic momentum then certain cyclical sectors such as financials and consumer discretionary are likely to suffer as well. We recommend holding a diversified equity allocation with a tilt toward higher-quality, more defensive strategies. Lower beta managers with exposure to more defensive areas of the market should provide better downside protection. Relative value strategies appear to have a more attractive risk-reward profile than deep value portfolios. On the growth side, “growth at a reasonable price” (GARP) strategies should be more resilient compared to high-growth managers if interest rates continue to rise.

Result

Nearly every segment of the fixed-income market has been negative over this time period. Shorter-duration strategies within the investment-grade and high-yield sectors have provided better downside protection, as longer-duration portfolios have suffered from a sharp rise in interest rates over the last few months.

Outlook

We continue to recommend shorter duration for fixed-income portfolios. The Fed is seemingly committed to fighting high inflation, telegraphing an additional six rate hikes this year after the first increase in March. Although the curve has already shifted up meaningfully in early 2022, we continue to forecast higher interest rates over the intermediate-term.

Result

Real assets such as REITs, MLPs and infrastructure have performed well in recent periods. Despite a modest pullback to start the year, REITs have handily outperformed the S&P 500 over the last two quarters. The outperformance of midstream energy stocks has been even more pronounced, as soaring oil and gas prices boosted MLP returns.

Outlook

Real assets have historically performed well in the face of high inflation. These segments of the market have generated significant alpha over the last year and a half so expectations of future performance should be adjusted accordingly. OAM slightly downgraded the asset class in last quarter’s Viewpoints to advise some profit-taking after strong recent gains. Still, we remain optimistic given the macro backdrop.

Result

Diversifying strategies have provided much better portfolio protection over the last two quarters, as traditional fixed income has suffered mightily from sharp rises in interest rates. Specifically, merger arbitrage strategies have posted flat returns while core fixed income fell sharply.

Outlook

We continue to prefer hedging equity risk with diversifying strategies rather than traditional fixed income in today’s environment. If interest rates continue to rise, then the correlation between equities and fixed income may also rise, suggesting that traditional bond allocations won’t provide the same level of protection as in the past. Uncorrelated strategies such as merger arbitrage should improve portfolio diversification. And these portfolios have historically performed well amid rising rates.

Contact an Oppenheimer financial advisor today to discuss how to combat inflation in your portfolio.