Sticky Inflation Is Back. Here’s How to Protect Your Portfolio.

It wasn’t all that long ago that investors were bracing for a recession. Now, the pendulum is swinging the other way, to an economy that’s potentially running too hot to allow inflation to continue on a downward path.

After a two-year campaign by the Fed to control price pressures in the economy, “inflation being stubborn and sticky” is a bigger risk for markets right now, says Tim Murray, a capital market strategist at T. Rowe Price.

The overall inflation rate is 3.2%, much lower than the 40-year highs the economy notched in the summer of 2022 but still higher than the Fed’s target.

After months of steady progress in 2023, January and February brought readings on inflation from the Consumer Price Index that were higher than economists expected. Many analysts anticipated higher readings in January thanks to seasonal factors, but last month’s data was further evidence that the “last mile” in the inflation fight will be bumpy. A separate measure of producer prices released this week also exceeded expectations.

“[February’s CPI] report should worry inflation optimists more than last month’s,” Preston Caldwell, chief US economist at Morningstar, said Tuesday.

The risk that inflation will meaningfully reaccelerate in the coming months is relatively small, economists say, but the risk that inflation will simply stop improving is much larger. That has investors worried: Stubborn inflation could derail the interest-rate cuts that both investors and central bankers are expecting later this year. Markets don’t like surprises, and a major change in the likely path of Fed policy could mean losses across stock and bond markets.

“That lack of disinflation is the bigger risk, near-term, for the markets,” says Jason Draho, head of asset allocation, Americas, at UBS Global Wealth Management. “If that continues, even the Fed cutting rates three times this year might be a stretch.” That could mean major repercussions for the economy and weigh on the prices of financial assets like stocks and bonds.

But it’s not all bad news. Strategists say investors still have opportunities to insulate their portfolios from sticky inflation. Here’s everything you need to know.

What’s Driving Inflation Higher?

All inflation isn’t created equal: A variety of underlying forces can push prices higher. In the aftermath of the coronavirus pandemic, for instance, prices rose dramatically thanks to wide-ranging disruptions to global supply chains.

“When inflation was really extreme, it was mostly about goods inflation,” T. Rowe’s Murray explains. That includes energy, food, and consumer goods—from cars to paper towels. The forces driving those prices higher have abated as global supply chains have recovered, though some economists worry that this progress could stall or even reverse in the months ahead.

Today, a different set of forces is keeping the inflation rate higher than the Fed would like. “It’s almost all about services inflation,” Murray says. That includes shelter costs, which have proved especially difficult to control, along with medical care costs and transportation costs like airline fares. Rising wages in a strong labor market also play a major role in services inflation.

Investors looking to protect their portfolios from inflation should consider the underlying drivers of rising prices, according to UBS’ Draho. A strategy that works to offset inflation caused by rising oil prices might not be as effective if inflation is ticking up because of soaring residential rents, for instance.

“It’s not as if you pick one and say, ‘I’m covered on inflation,’ because the reasons can vary quite a bit,” he adds.

Protecting Against Goods Inflation

Goods prices are driven in large part by the supply and demand of commodities, the raw materials that are used to produce and transport consumer products, such as metals and chemicals. When supply constraints are pushing prices higher, according to Draho, energy and oil stocks can be an effective hedge.

“Energy is such a big input into every commodity,” says Murray. “As a result, commodities broadly tend to follow energy.”

When commodity prices rise and drive up the price of goods, energy prices tend to rise, too. That’s why “oil and energy equities are one of your better ways to hedge goods inflation risk,” Murray says. The same logic is true for industrial materials, and Murray points to natural resources-oriented funds as an easy way for investors to gain exposure to those stocks.

Hedging Strategies for Services Inflation

Wage inflation is a major driver of services inflation, according to Murray, who points to REITs—residential REITs in particular—as a way to hedge against gains in this component of the CPI.

“When wages go up, rents also tend to go up because people can afford more,” he says. As rents rise alongside wages, those REITs will make more money.

However, Murray cautions that there’s often a lag between rising wages and higher shelter inflation. Not to mention the fact that REITs often fall when interest rates rise. “There’s just a fair amount of noise,” he says.

Broad-Based Inflation Strategies

For investors who’d rather stay out of the weeds, there are also a few market truisms worth keeping in mind.

“Stocks are a better asset to own during inflationary periods than bonds,” Murray says. When you’re worried about inflation, he adds, it makes sense to tilt your portfolio toward equities. Rising interest rates tend to boost valuations, and higher inflation means higher earnings (in nominal terms). Higher earnings mean better stock performance.

Bonds, on the other hand, are often used as a hedge against recession but struggle when inflation is elevated. Murray also cautions against rate-sensitive sectors like utilities and consumer staples, though he acknowledges that valuations on both those sectors are attractive right now.

UBS strategists also point to hedge funds, which can offer portfolio diversification when both stocks and bonds are down.

A Diversified Portfolio Is the Best Hedging Strategy

No one has a crystal ball when it comes to the path of the economy or financial markets. Draho points out that while sticky inflation is certainly a risk for markets, it’s also very possible that inflation will improve and the economy’s growth will hold up.

An investor who prepared solely for an inflationary scenario would miss out on gains in that scenario. It doesn’t make sense to eschew bonds completely, for instance, because it’s still very possible that higher rates will eventually trigger a recession.

Draho’s rule of thumb? “You have to be invested and you have to be diversified.”

He recommends incorporating a few different hedging strategies around the edges of your long-term strategy. “At the margin, where do you want to make adjustments?” he says. “Because things can go different ways. And if it’s not inflation … you want to have other things to be invested in across the portfolio.”