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Should You Worry About Inflation and Your Portfolio?

Life stage makes a difference.

Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. Inflation remains quite low here in the United States, but does that mean investors should disregard it entirely? Joining me today to discuss the topic is Christine Benz. Christine is Morningstar's director of personal finance. Christine, thanks for joining us today.

Christine Benz: Susan, it's always great to be with you.

Dziubinski: Now Federal Reserve chairman Jerome Powell has noted that he's a little bit concerned about the very low rates of inflation that we're experiencing. So much so that the Fed is going to engage in a program to help nudge up inflation a little bit. What factors have been contributing to keeping inflation as low as it's been?

Benz: It's mainly this pandemic, which has had major economic ramifications. We've seen unemployment spike recently. We've also seen many people naturally curtail their spending as they've experienced income shocks through this period. And we've also just seen economic activity, industrial output decline during this period as well. All of these things tend to keep the brakes on inflation.

Dziubinski: And this is part of a longer-term trend, too, right, Christine? I mean, we have been experiencing lower inflation.

Benz: Absolutely. Coming out of the last financial crisis in 2009, I think many investors were warned to kind of brace themselves for inflation that never really did materialize following that crisis. We've had a period of very low inflation, and even some areas that had historically been big contributors to inflation, like healthcare costs, actually came down a bit during the previous decades.

It's been a very tranquil period. I think it would be hard to blame investors for considering inflation kind of a nonissue at this point.

Dziubinski: Given that backdrop, why is there some talk right now about inflation and people perhaps being concerned about it?

Benz: Well, a couple of things. One is that as with the last financial crisis, we've seen so much government spending, attempting to ignite the economy. And we've also seen interest rates come way, way down--again in an attempt to stoke the economy. And so these things historically have been inflationary even if they weren't after the last financial crisis.

Anytime you throw this much economic stimulus at an economy, the concern is that higher prices could follow, that things could get a little too hot, and that some of these mechanisms might overshoot a little bit. So that's a sort of a fundamental concern, and we have begun to see a few indications that investors are being a little bit more concerned with inflation.

What's called the "breakeven rate"--which is the differential on what you earn on an inflation-protected bond versus a nominal Treasury bond--we've seen that breakeven rate come up a bit. It's still not high, but it's definitely back to the levels where it was prepandemic. That's one signal that investors are paying a little bit more attention to inflation.

And then another thing that you and I have talked about, Susan, is the fact that we've seen the dollar drop relative to other major foreign currencies. And there are lots of conjectures about why that might be happening. And then there are lots of factors that affect a currency's direction relative to other foreign currencies. But one conjecture in the mix is that investors in dollar-denominated assets are worried about inflation in the U.S. So just a couple of things that investors might want to keep on their radar.

Dziubinski: Given all of that, how concerned do you think investors should be about inflation at this point in time?

Benz: Well, as I've mentioned, we have had periods before where there was a lot of hand wringing about inflation being imminent and it never really materialized, and the most recent financial crisis was a great example of that. And then I always say for people who are working and earning a paycheck, they should bear in mind that they typically are over time at least eligible for cost of living increases in their paychecks. And if they're not withdrawing from their portfolios, there's probably not a reason to be inordinately concerned with inflation.

And then another thing to keep in mind for younger investors and anyone who is, say, 10 years from retirement, you've probably got the bulk of your portfolio in stocks, which, while not a direct hedge against inflation, have historically outearned inflation. For those folks, I would say there's probably not a big reason to be too concerned about inflation today.

Dziubinski: What about those who are closer to retirement or already in retirement?

Benz: That's a separate issue, and the key reason is that for people at this life stage, even though a portion of the income they receive is probably going to be inflation-adjusted in some fashion. So if you get Social Security, you may not be satisfied with the inflation increase that you receive, but you typically do receive a little bit of extra income to compensate for inflation. So that portion of your portfolio is inflation-adjusted or that portion of your income stream. 

On the other hand, the portion that you're withdrawing to meet your living expenses is not automatically inflation-protected. That's the portion of your portfolio, if you're retired or getting close to retirement and you're getting close to drawdown, that I do think it's worthwhile to look at that portfolio and make sure that you've laid in a little insulation against inflation. And I don't think you want to wait around for inflation to materialize to do that--that you want to be pre-emptive--because if inflation starts picking up, it can often do that in a hurry. I like the idea of investors who have bonds in their portfolio allocating some of those assets to Treasury Inflation-Protected Securities, which are the most direct hedge against inflation in that, if inflation goes up, you receive a little bit of a pickup in your return to account for inflation. So TIPS, Treasury Inflation-Protected Securities. 

And this is another reason, Susan, why I like recommending equities for retirees as well. Which is not to say all of their portfolio should be in equities, but holding some stocks does help protect your purchasing power or at least gives your portfolio the opportunity to grow at a faster rate than inflation.

I would say those would be the two key prescriptions. And then you might also think about some asset classes around the margin. Real estate investments have historically had some inflation-hedging characteristics in part because if you're a landlord of some kind, you can typically push through higher rent increases when inflation is on the rise.

Commodities also show reasonably well relative to inflation. The downside to commodities is that they're incredibly volatile as stand-alone investments. They can be higher-cost products. I'm not as bullish on them. And precious metals I know a lot of investors like to gravitate to in periods of inflation. When we at Morningstar look at asset classes' inflationary characteristics, inflation-hedging characteristics, precious metals don't even look all that great. So you might hold precious metals for other reasons, but I wouldn't hold them as definitely a significant hedge against inflation because historically they haven't been wonderful from that standpoint.

Dziubinski: Christine, it sounds like it might be a good time for retirees to do a little inflation-protection checkup on their portfolios. Right?

Benz: Definitely.

Dziubinski: Thanks for joining us today, Christine, and for all the insight. We appreciate it.

Benz: Thank you, Susan.

Dziubinski: From Morningstar, I'm Susan Dziubinski. Thanks for tuning in.