By Philip van Doorn
Shift bond exposure, add gold and other commodities, and look for dividend increases in the stock market.
Inflation is back, and the question for investors is whether it is a blip caused by pent-up demand as the economy opens up. If you believe a sustained period of high inflation has begun, this is the time to reconsider your investment allocation.
Economists cite contradictory evidence when discussing the broad movements of prices for assets, goods and services, so your own opinion might be as good an indicator of the inflation threat as any other.
What follows are comments from an economist and three money managers that might point you in safer directions in an environment of higher inflation and rising interest rates.
First, we'll consider defensive moves for income portfolios and then look at stocks.
Fear of rising interest rates
When interest rates rise, bond prices fall. For now, interest rates remain low, underscoring how some investors might have itchy trigger fingers if they see more signs of inflation. There's plenty of real evidence, including a 2.6% increase in the consumer price index over the previous 12 months, which was the largest increase in two and a half years ().
There's also the inflation of asset prices: The broad stock indexes are near record levels, which itself isn't necessarily a bad sign. But their price-to-earnings ratios are high. For the S&P 500 , the aggregate forward price-to-earnings ratio is 22.2, compared with 17.2 two years ago, according to FactSet.
Then turn to the U.S. housing market: The S&P Case-Shiller 20-city home price index was up 11.9% () in February from a year earlier. Rental markets are strong outside the largest U.S. cities and are recovering in several of the biggest ones.
Then there's anecdotal evidence. If there have been houses for rent in your neighborhood, maybe you have noticed a lot of people driving by to check them out.
And have you tried to buy lumber this year? You may be in for a rude awakening.
"Take note of the anecdotal. It tends to be a leading indicator to the official data," said Michael Cuggino, president and portfolio manager of the Permanent Portfolio Family of Funds, which is based in San Francisco.
Cuggino said the quick spike in yields for 10-year U.S. Treasury notes that started in mid-February "was partially in response" to the risk of inflation.
He said there's no comparison between the 2021 recovery from the coronavirus pandemic slowdown to the bounce-back that followed the credit crisis of 2008. The response by the government and Federal Reserve today dwarfs that of the financial meltdown of a dozen years ago.
Plus, money today is going to Main Street -- extended and increased unemployment benefits, moratoriums on foreclosures and evictions, among other programs. During the previous crisis, banks were bailed out and stocked with liquidity. "Our banking system is very strong as a result," he said.
Matthew Pallai, the head of multi asset solutions at Harbor Capital Advisors, concurred.
"It is fairly new that fiscal stimulus has been paired with monetary stimulus. Those two forces are working together to put upward pressure on inflation," he said.
"So you are starting with very low production numbers (and now) have increased liquidity chasing around fewer goods and services," Cuggino said.
Moves you can make
Patrick Zweifel, the chief economist at Pictet Asset Management, said: "As long as inflation is essentially driven by strong growth -- demand-driven inflation -- risky assets tend to perform well." Those include high-yield bonds and stocks, he said.
Pallai said "right now, we are more likely seeing demand-driven inflation" than supply-side inflation, because "the consumer is in a pretty good spot from an income perspective, from a savings perspective -- better than it has been in quite some time."
During a period of high demand and high inflation, Zweifel expects traditional inflation hedges -- gold, other commodities and housing -- to perform well. But he would expect even better performance from gold and commodities if the environment were to change again, to one of high inflation and slower growth.
The price of gold, based on continuous forward-month futures on the New York Mercantile Exchange (ABX.T), has increased only 13.5% over the past 10 years, according to FactSet. Cuggino said opinions of gold are closely tied to investors' time range.
"When interest rates rise, gold goes down from the knee-jerk reaction. Then gold inches back up," Cuggino said. So you should expect short-term volatility for gold if there is a strong market.
Cuggino pointed out how patient a gold investor might need to be: "From the early- to mid-1980s to 2000, it was in a trading range of $200 to $400 an ounce. It did nothing for 15 years."
Then from 2000, gold rose to an eventual trading range of $1,179 to $1,924 in 2011-2013.
"So you basically got a four or five time return on the low end of the trading range through 2013," Cuggiono said. And after that, gold went through another range-bound period through mid-2019, when it began an upward climb.
Gold is not an easy play. It may be best for a small portion of your portfolio if you can remain committed for many years, preparing to make a quick move out if it soars during a multi-year period of high inflation.
The $2.6 billion Permanent Portfolio , which Cuggino has run since 2003, was 13.5% invested in gold bullion as of March 31. The fund is conservatively managed across various asset classes with the objective of "a smoother return long-term, to build a nest egg that exceeds inflation," Cuggino said. The fund is rated three stars (out of five) by Morningstar.
Altering the mix of assets
Pallai advises investors to think carefully about asset allocation. "If it is an investor thinking from a long-term perspective, you must always avoid making snap judgments and reacting to a current situation," he said.
No economist or investment adviser has a crystal ball. Cuggino's approach is to aim for an "all-weather portfolio" to reduce risk over the long term while also seeking capital growth from various investments, including stocks.
Pallai suggests an investor who has a strong opinion that inflation will be higher five years from now than it is today, prepare by owning "less in high-quality fixed-income (investment-grade bonds or bond-fund shares) right now. That is going to be in a tough spot in a rising-rate environment."
"So maybe put some income exposure into the short-term credit markets, secured assets, bank loans, emerging-market debt."
By doing so, you can find "similar yields with more spread duration," he said.
Credit risk and inflation risk peak at different times. Lower-rated bonds and loans tend to perform well during inflationary periods because "the assets you are lending against are going up in price, so you are effectively getting more collateral," Pallai said.
There are various vehicles for increasing credit exposure while pursuing yield, including real estate investment trusts, or REITs, and business development companies, or BDCs, as well as high-yield bond funds.
The latter, especially with relatively short durations, might work out well over a long inflation cycle because the continual maturity of bonds means money can be quickly reinvested in new higher-yielding paper by the fund managers.
Click here () for more about investing in REITs in a decidedly mixed environment and here ( ) for more about business development companies.
Michael Clarfeld is a member of the Income Solutions team at ClearBridge investments, a subsidiary of a subsidiary of Franklin Templeton in New York. He co-manages the $7.2 billion ClearBridge Dividend Strategy Fund , which has a three-star rating from Morningstar.
Clarfeld made it clear, as did everyone interviewed for this article, that he didn't know if the current inflationary cycle would be a short-term phenomenon or a years-long slog. But he believes "dividend stocks are a great place to be if you are worried about inflation."
"We think dividend growth will be robust, because the economy will be. Earnings will be strong," he said. And that could make a dividend-stock portfolio less risky than a high-quality long-term bond portfolio. Those bonds won't increase their interest payouts as their market values decline in a rising-rate environment.
With the stock market at "fuller levels," Clarfeld said investors should be looking at certain sectors where valuations aren't too high, including consumer staples, banks and energy pipeline operators.
Among providers of consumer staples, Clarfeld favors Procter & Gamble Co. (PG). and Coca-Cola Co. (KO).
"Most of the staples had terrific years last year, but Coke has a big on-premise business, which was down. They should see more upside from the recovery," he said.
Among banks, Clarfeld likes Bank of America Corp. (BAC), "which we think is conservatively run these days." He also holds shares of JPMorgan Chase & Co. (JPM) in portfolios he manages, though that is a smaller position.
Clarfeld emphasized the importance of dividend growth -- not necessarily high current yields. So he also listed Visa Inc. (V), Mastercard Inc. (MA) and American Tower Corp. (AMT).
Read:Have you held any of these 20 stocks long term? Your current dividend yield might surprise you ()
2021-05-03 16:04:00 GMT MW If you think inflation poses a long-term -2-
When asked about Apple Inc. (AAPL) and Microsoft Corp. (MSFT), which have low dividend yields, Clarfeld said: "We have large positions in both. We think MSFT is better positioned for better fundamental growth. Apple is going to be a solid grower but at a lower rate."
Cuggino also favors dividend stocks in a rising-rate environment. He named three that are in portfolios he manages and are "relatively cheap": Freeport-McMoRan Inc. (FCX), Lockheed Martin Corp. (LMT) and Morgan Stanley (MS).
As a miner of copper, gold and other metals, Freeport "might be a good one" for an inflationary environment, Cuggino said, while he likes Morgan Stanley for the prospects of higher net interest margins when interest rates rise. When discussing Lockheed Martin, he said that "defense is somewhat inflation-neutral, since you need it."
He believes all three have "long-term staying power" and are trading at attractive price-to-earnings multiples.
When asked if the strong performance of technology companies achieving double-digit sales growth might continue in any economic environment, despite high P/E valuations, Cuggino said, "We own Nvidia (NVDA)."
Here are dividend yield and forward P/E ratios for the stocks mentioned by Clarfeld and Cuggino:
-Philip van Doorn; 415-439-6400; AskNewswires@dowjones.com
(END) Dow Jones Newswires
May 03, 2021 12:04 ET (16:04 GMT)
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