The Impact of Inflation on Stocks and Bonds

In the following excerpt from her recent webcast, "Your 2022 Midyear Portfolio Checkup," Morningstar director of personal finance and retirement planning Christine Benz discusses:

• How inflation affects you.
• How to protect your investments against inflation.
• What types of bonds do well when inflation is high.

Watch the full webcast: Your 2022 Midyear Portfolio Checkup.

Christine Benz: Now I want to talk about inflation. Inflation has certainly been hard to ignore. We've seen inflation rise really sharply over the past year, and this has been a real turnabout. We talked earlier on about how the turnabout in interest rates has upended what had been kind of a long-standing regime. The selloff in stocks has upended what had been a really comfy period for equityholders. Similar with inflation. Where I think many of us had gotten somewhat complacent about inflation; it had sort of plodded along at kind of a 2%, even sub-2% sort of zone for many years.

How Inflation Affects You

Recently, as you all know, the inflation rate has jumped up very dramatically into the 8% range as of its most recent reading. So, this complicates planning. I would argue that it particularly complicates planning for older adults who are drawing from their portfolios. So, the reason that it's worrisome for older adults is that older adults typically are drawing a percentage of their living expenses from their portfolios and they're also typically holding safer investments in their portfolios. They may hold some stocks, but they are also holding some fixed-rate investments. They're holding bonds; they're holding cash. And unless you go out of your way to add inflation-protected bonds, the payments you receive from those fixed-rate investments are not automatically inflation adjusted.

So, I think it's worthwhile to think about your personal inflation situation as a starting point for thinking about how worried you should be about inflation. So, I like the idea of looking on your personal spending, looking at your pattern over the past year or the past several years to think about what your personal spending rate is and in turn your personal inflation rate. I've written about this topic before. I created a little calculator to plug in your own spending and your own inflation calculation to come out with a customized inflation rate.

More on the topic from Christine: What's Your Real Inflation Rate?

And I also always have to credit this concept to Jason Zweig, because probably 10 years ago, he wrote about the importance of not just taking CPI and running with it but instead using kind of a personalized inflation rate. So, I think, that's the starting point for this process, for customizing your inflation rate. You may find that your personal inflation rate is higher than CPI, but if you're someone who doesn't drive a lot, for example, you may find that your personal inflation rate is actually a little bit lower. So, run the numbers on that.

And then, the next step is to look at your sources of cash flow, your sources of income. Some people find themselves in the position of being at least somewhat insulated against inflation. A good example would be people who are earning paychecks and eligible for cost-of-living adjustments in those paychecks. Their increases may not make them whole with respect to inflation. So, if inflation is up 9% this year, not everyone's getting a 9% raise this year. But generally speaking, employers have been attuned to the fact that inflation has been higher, and they have been giving employees a raise. People who are on Social Security are also getting an adjustment. Social Security recipients received a 6% inflation adjustment for 2022. So, for retirees who are taking a big share of their income needs from Social Security, they're at least somewhat protected from the standpoint of inflation. And then, people who receive government pensions typically receive nice cost-of-living adjustments to account for inflation. These are the groups who are at least somewhat insulated from inflation.

In terms of who is not insulated, I mentioned people who are earning interest who have a lot of their portfolios in fixed-rate investments, who have a lot of their assets in cash, who have a lot of their assets in bonds, those interest-rate payments that you receive from the bonds are not automatically inflation-adjusted. If you just hunker down in a money market fund, for example, for your whole retirement account when inflation flares up, as it has recently, it will eat a hole in the payouts from your portfolio. Private corporate pensions aren't typically inflation-adjusted, either. So, if you look at your retirement plan and a big share of your income is going to be coming from a pension, well, ask some questions about whether any inflation adjustments are in play. Oftentimes, that's not the case. So, you'd want to make sure that you're taking steps to insulate your plan against inflation.

How to Protect Your Investments Against Inflation

How do we think about inflation protection at the portfolio level? Well, when we think about the categories that are direct hedges against inflation, that would be inflation-protected bonds, so Treasury Inflation-Protected Securities, or TIPS, would be one category. I Bonds would be another category. They are relatives. They tend to work in a similar way. Both are bonds, so they issue interest, and they also provide you an inflation adjustment to help you keep pace with inflation. So, I was talking about how nominal bonds and certainly cash investments are very, very vulnerable to inflation. TIPS and I Bonds have a built-in hedge to help you keep pace with inflation. I Bonds have issued very attractive yields. The new I Bonds coming to market have very attractive yields, in part because of the inflation-adjustment piece. One key thing to keep in mind though is that purchase constraints limit how much people can put into I Bonds. So, even though they're a great component of investors' portfolios, you may be curtailed in how much you can put in, how much of your portfolio you can put into them. So, you may want to augment that position with a position in Treasury Inflation-Protected Securities or a fund that invests in them. My preference is for the shorter-term TIPS funds because they tend not to capture a lot of that interest-rate-related volatility that comes along with intermediate-term TIPS.

More on the topic from Christine: TIPS Versus I Bonds

Stocks are another thing to think about when you're thinking about how to make sure that your portfolio is inflation-protected. I want to clarify that stocks are by no means a direct hedge against inflation. So, we have a lot of inflation so far in 2022. Stocks are down. So, there's not that one-to-one offsetting effect with stocks. But over long periods of time, stocks have tended to outearn the inflation rate. So, they've tended to help you keep pace with or perhaps earn higher returns than the inflation rate.

Then a few niche categories that I would mention in the context of inflation. Real estate, certainly real estate investment trusts. The companies that own these properties are typically able to push through rent increases in inflationary periods, and we've certainly seen higher rents come on line in many contexts within the real estate space. So, real estate is generally considered a decent inflation hedge. That's why I think it makes sense as a component of most investors' portfolios. If you own a total stock market index or something like that, you're certainly getting a little bit of real estate equity exposure there.

Commodities have performed very, very well in inflationary periods where we've seen them come on strong this year. Whether you want to add to them now, if you haven't had them in your portfolios, I think is an open question, because the risk is that if the economy cools, if inflation cools, investors' appetite for commodities could cool as well, and commodities have just been incredibly volatile over time.

More on the topic from Christine: For Inflation Protection, Commodities Belong in the 'Too Hard' Pile

What Types of Bonds Do Well When Inflation is High

Bank-loan investments, sometimes called floating-rate investments, can also be a nice tool to think about adding to your portfolio. They have generally performed reasonably well, certainly better than high-quality bonds during this period. High-yield bonds are another category to consider as a component of your fixed-income portfolio. I wouldn't hold either of these investments as kind of the main course within my fixed-income portfolio. I'd own them as sort of aggressive kickers within my fixed-income portfolio. But, in general, they will tend to hold up better than high-quality bonds in an inflationary environment.