There has been news circulating about rising inflation, and it has many people concerned. However, oftentimes the headlines fail to mention that inflation is always present in a healthy economy, and it is not necessarily a bad thing. Inflation is representative of growth that is necessary for recovery after a tumultuous economic crisis. Consumer prices rose 4.2% in the 12-month period ending in April, which is the largest increase in over a decade.
Many economies are now reopening, and people are also preparing to spend more after being stuck in their homes for more than a year. As the vaccination rate surpasses 44%, inflation is expected to continue to rise. Prices of commodities could continue to increase with the government strategizing to offer another fiscal aid to citizens.
The term “inflation” brings worry to a lot of investors, but there is no need to panic. The best strategy for investors during a period of inflation is to be vigilant and make changes to their portfolio allocation as needed to keep inflation at bay. Here are some moves to not just get through this period of rising prices, but possibly prosper as well.
The Problems Presented by Inflation
Inflation first hits an economy with a decrease in purchasing power, meaning that commodities prices start moving up without an extra source of income for consumers. It results in the cost of living going up, while at the same time the returns on people’s savings and investments do not stretch as much as needed to cover those higher costs.
This creates a problem especially for retirees, because most of them rely on their savings to sustain their lifestyles and take care of their bills. We will have a close eye on the Federal Reserve in the coming months. One important question on investors’ minds is whether stocks and U.S. Treasuries will remain negatively correlated, meaning that when stock prices fall, bonds prices tend to rise. Given the continued strength in inflation data, this would seem unlikely.
If yields continue higher, bonds may be a dangerous asset class to own here in the U.S., particularly if the dollar significantly weakens. Bond traders think the Fed will be forced to act sooner than it wants. Former Fed governor Bill Dudley has expressed his concern that the Fed may need to raise rates to upwards of 4.5% to cool an overheating economy (source: The Economist, May 15, 2021).
Areas Investors Should Avoid
As an investor, making smart, thoughtful decisions by really understanding what you own is the only way to manage inflation and potentially benefit. This means thinking strategically about your assets. Investors can address this potential rise in inflation by ensuring that they reallocate their investments to limit risk.
For example, inflation periods are a good time to avoid tying money to any long-term bond or certificate of deposit, because it may result in loss due to the higher rates expected later.
How Investors Can Prosper with Rising Inflation
The big question is, how can an investor preserve and grow assets with rising inflation? One strategy is to invest in value stocks.
Typically, a value stock has an equity price lower than the stock prices of companies in the same industry. Therefore, a value stock is trading at levels that are perceived to be below its fundamentals. Common characteristics of a value stock include high dividend yield, a low price-to-book ratio (P/B) and a low price-to-earnings ratio (P/E). A value stock will have a bargain price due to being seen as unfavorable in the marketplace. They hold the potential to emerge from this undervalued position and offer strong current cash flows for investors.
There is correlation between value stocks and performing well during inflation because their value is less affected by rising interest rates. This is in contrast to growth stocks, which are often negatively affected by inflation because their value is expected to appreciate in the future. When interest rates are on the rise, this future appreciation of value is harmed. While value stocks offer risks of their own, they tend to be firmly established companies, so investors do not need to worry about expected growth values impacting their investments.
Value stock companies tend to be firmly established, which means investors do not need to worry as much about expected growth values impacting their investments.
Other Considerations Investors Can Make
Another consideration for investors is tangible assets. Namely, real estate. In the real estate environment, if inflation increases, estate managers or landlords can ensure the inflation costs are channeled to the tenants by raising rents year over year. Additionally, the value of the property itself typically continues its upward trajectory alongside the rent escalation.
It's Time to Invest
Inflation does not spell disaster for investors. Instead, the goal of investing during a period of inflation should be to preserve portfolio buying power and ensure that investments keep growing to achieve the investor’s goals. Inflation brings new opportunities for portfolio diversification, which only stands to help investors build a more robust array of assets that are equipped to withstand market instability.
When in doubt, working with a financial adviser can help investors determine the best way to allocate their resources for maximum growth, even with inflation on the rise.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.