Worries about rising inflation are spooking stock and bond investors. As the global economy improves and U.S. tax cuts spur more spending, many believe that the long era of low inflation is probably behind us.
So how should you adapt to the new economic order?
As a reminder, inflation occurs when the prices of goods and services rise, and as a result, every dollar you spend in the economy purchases less. The annual rate of inflation over from 1917 until 2017 has averaged just over 3 percent annually. That might not sound like much, but consider this: today you need $7,272.09 in cash to buy what $1,000 could buy 50 years ago.
It’s been a long time since the double-digit rates of 1979-1980. Inflation has hovered just above 2 percent over the past 20 years, despite repeated warnings that the Federal Reserve’s intervention during the financial crisis and its aftermath would spark a surge in prices. The relatively tepid recovery, combined with an aging population and technological advances, kept a lid on overall prices.
But in February, inflation alarm bells went off. Data showed that hourly wages had jumped by 2.9 percent in January from a year ago.
Currently, inflation is still running well below the long-term average pace. As of January, the government’s measure of inflation, the Consumer Price Index (CPI), increased 2.1 percent over the last 12 months (1.8 percent without food or energy costs included.)
If serious inflation is back, how can you prepare?
One easy action item is to lock in fixed-rate mortgages. Although you likely missed the rock-bottom levels of the cycle, borrowing for the long term is still historically cheap. If you are refinancing, you may want to fold in home equity loans or credit card debts that are tied to variable, short-term interest rates.
As far as investments, your goal is to grow your portfolio at a quicker pace than the rate of inflation, while keeping focused on the total risk level you are willing to assume. While no single asset acts as a perfect inflation hedge, consider the following:
Commodities: When inflation rises, the price of commodities like gold, energy, food and raw materials also increases. However, this is a volatile asset class that can stagnate or worse, lose money, over long stretches of time. Therefore, investors would be wise to limit commodity exposure to 3 - 6 percent of the total portfolio value.
Real estate investment trusts (“REITs”): The ultimate “real asset”, REITs tend to perform well during inflationary periods, due to rising property values and rents.
Stocks: Many investors don’t think about stocks as an asset class to combat inflation, but long-term data show that stocks, especially dividend-producing stocks, tend to perform well in inflationary periods. That said, during short-term inflationary spikes, the stocks might drop before reverting to the longer-term trend.
Treasury Inflation Protected Securities (“TIPS”): Rising prices can diminish a bond’s fixed-income return. But the US government directly offers investors inflation-indexed bonds, or TIPS, which proved a fixed interest rate above the rate of inflation, as measured by the CPI.
International Bonds: Inflation can shred the value of the U.S. dollar so consider a small allocation to international bonds, which are denominated in foreign currencies.
When inflation looms, it’s important to underscore that a diversified portfolio, which takes into account your time horizon and risk tolerance, will go a long way towards providing protection. If you are worried about inflation, these other asset classes should be used sparingly to round out your overall allocation.
A CFP® professional can help you create a diversified portfolio, and adjust it when economic circumstances change.