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How to Protect Your Portfolio From Inflation

They have varying levels of effectiveness, but here are some ways to hedge inflation risk.

The article was published in the August 2021 issue of Morningstar FundInvestor. It has been updated with the latest inflation figures. Download a complimentary copy of FundInvestor by visiting the website.

Inflation is here. On Oct. 13, 2021, the Consumer Price Index was reported to rise 0.4% in September, but it is up 5.4% from pandemic-depressed price levels a year ago. Bond markets modestly sold off over the course of the year in reaction to the uptick in prices.

Why hasn't the bond market taken a bigger hit? Some of the price surges are clearly temporary. The economy slammed on the brakes when the coronavirus hit in the spring of 2020, and now it's hitting the gas. Both events caught the global supply chain off guard, but there are also just natural bottlenecks like global shipping capacity, car supply, and so on. One third of the latest increase in the CPI was used-car prices. A year ago, car rental companies dumped their fleets on the market, and now they are scrambling to buy enough cars to meet demand as travel ramps up. That won't continue. On the other hand, global supply bottlenecks continue as container ships are stacked up at California ports.

Another element to factor in is that economic figures are generally reported in comparison with 12 months ago, and we know that 12 months ago the economy was grinding to a halt, and the prices of many items were falling. So, that 5.4% figure overstates the real increase.

In fact, other products like lumber have had huge price spikes only to fall back to levels below the start of the year as supply catches up with demand. But other areas may remain elevated. Tariffs on Chinese semiconductors have curbed supply in the United States and slowed down production of a wide array of products, including autos and household appliances. In addition, wages for the lowest-paid blue-collar workers have bounced up and figure to remain higher for at least a while. (Click here for Travis Miller's look at inflation's impact on utilities.)

A third reason inflation might stay higher is that many economists at and outside the Federal Reserve have come to think a little inflation is all right, and in the past, monetary policymakers have sometimes caused too much unemployment and economic harm by being overly vigilant about keeping inflation under wraps. Today, most economists expect inflation to be between 2% and 3% annualized for the next three years. That's an uptick, though not a huge surge. But the Fed and fiscal policy have certainly been geared to keeping the economy moving rather than halting inflation. And, of course, it also means the chances of a bigger surge in inflation have gone up somewhat.

So, let's talk about how inflation can affect your portfolio. Inflation affects different security types in different ways. Before I get to the details, the big picture is that inflation is a greater threat to a bond-heavy portfolio than a stock-heavy one. If you are 80% equities, then you probably don't need to worry about inflation. If you are 80% fixed income, then, yes, inflation is an issue.

It's also worth remembering that inflation is not the only threat to a portfolio. Many economic problems like recessions can hurt your portfolio, too. Stay focused on your goals. You don't want inflation protection to dominate your portfolio. Anyone who put on a lot of inflation protection the past 20 years probably missed some robust gains. Remember all the predictions about inflation spikes in 2009? Didn't happen. Economic forecasting remains a dicey endeavor

Direct Hedges

Treasury Inflation-Protected Securities Treasury inflation-adjusted securities are designed to protect against inflation by adjusting the value of the underlying bond up when inflation rises and down when inflation declines. This makes Treasury Inflation-Protected Securities and TIPS funds the purest hedges against rising inflation. Other bonds and bond funds are vulnerable to some degree to rising inflation, but TIPS are impervious.

The mechanism for adjusting to inflation makes for two unusual attributes in TIPS funds. Although the securities adjust the principal, that adjustment shows up as income for purposes of the SEC yield. Thus, for short periods you can get a misleading SEC yield of 6% or 7% when inflation picks up. In truth, TIPS yields are typically 2% or less.

The second quirk is that the IRS taxes that adjustment as income. That means you can pay a lot of taxes when inflation perks up. The answer here is to hold these funds in tax-sheltered accounts like IRAs and 401(k)s.

The final issue to keep in mind is duration. TIPS are sold in maturities of five, 10, and 30 years, and you can find short-term and long-term TIPS funds. Because TIPS have low yields, they are more interest-rate-sensitive than bonds of similar maturity. Unless you are buying a short-term TIPS fund, you are likely getting a fair amount of interest-rate risk. Yes, inflation and interest rates often go in the same direction so that they may offset for TIPS investors. But that’s not always the case. There have been times when TIPS funds lost money because interest rates rose but inflation expectations did not.

Commodities Another way to hedge inflation risk is through a commodities fund. Typically, commodities funds invest in derivatives linked to a commodities basket. Commodities prices are an important part of inflation and are generally sensitive to economic growth and inflation. If you think about times when oil prices spiked, inflation often followed in its wake. I mentioned car prices and lumber as two elements in recent inflation surges. Obviously, a commodities fund would have captured the pop in lumber, and in some of the commodities that go into cars, but not the price jump of the cars themselves.

Commodity prices tend to swing much more dramatically than inflation, but that makes them more of a hedge against inflation. Pimco Commodity Real Return Strategy PCRAX gained a hefty 50.4% for the 12 months ended July 2021. The fund invests in a basket that has equal parts energy, agriculture, and metals exposure. It then invests some of the money for collateral against those derivatives in a short-term TIPS portfolio.

It's a sophisticated, complicated, well-run strategy. Yet, the fund lost money in five of the past 10 calendar years, and four of those five were double-digit losses. Commodities, unlike bonds and stocks, don't have a natural return built in. The next move is as likely to be up as down. So, if you buy a fund like this, keep it to a small position. I wouldn't let it get to even 5%.

Morningstar's Christine Benz argues that volatility makes commodities funds too difficult to be worth owning. It's a valid point. I would keep the position small for the reasons listed above and in Benz's article.

Indirect Hedges

Equities Now the good news: You've already got some inflation protection because you own stock funds and stocks. The link isn't perfect. If news of a jump in inflation breaks in the morning, stocks might sell off that day. But over the long haul, stocks tend to do all right when inflation rises. The first reason is simply that inflation applies to all assets, including stocks. If workers are getting raises, they can afford a little more in dollar terms to invest in stocks. Also, many companies have pricing power that allows them to raise prices. Companies with strong brands or that operate oligopolies can pass prices on to consumers. Not all companies will thrive, though. Some may see prices rise more in their supply chains than they can pass along. Think about oil prices and airfares. Airlines will pass on a surge in oil prices in airfares, but travelers might balk at accepting the whole increase, especially if the economy isn't strong.

But, by and large, stocks are a pretty good place to be. So, inflation is less of a worry for investors with equity-heavy portfolios.

Bank Loans As I noted above, interest rates haven't always risen with inflation. But they often do as investors demand to be paid more to compensate for losses to inflation. Bank loans adjust up and down with changes in interest rates, so that makes bank-loan funds largely impervious to rising interest rates. Again, it's more adjacent to inflation rather than tightly linked. And bank loans have their own risks. Bank-loan funds tend to be mostly below-investment-grade or unrated loans, so you have credit risk. And bank-loan trades settle slowly, so there is some liquidity risk. The good bank-loan funds have proved to be adept at managing liquidity so far, but the challenge remains.

Gold If things worked the way gold bugs wanted them to, every global crisis and every uptick in inflation would send people clamoring to get a bit of gold. Yet it only sometimes happens. This year, gold funds are about 12% in the red. Gold stocks rallied beautifully in the 2000–02 bear market but lost money in the two bears that would follow. In short, returns are random, and gold stocks are vulnerable. Benz's point about commodities funds also applies here.

Somewhat Vulnerable

Outside of bank loans, bonds pay a fixed yield plus a set amount at the end. That makes bonds vulnerable to inflation because inflation devalues that future stream of payments. Thus, an inflation increase is going to hurt high-yield bond funds and intermediate taxable-bond or municipal-bond funds. Exactly how much depends upon changes in interest rates and the level of inflation.

Fairly Vulnerable

Long-maturity bonds with low interest payments, such as long-term muni funds and long-term government-bond funds, are the most vulnerable of all. Again, how much you'll lose depends on interest-rate moves.

No Idea

Cryptocurrencies are often promoted as a cure to everything wrong with the dollar and modern finance. There are limits on supply as you can't simply print more. Yet the link with inflation so far has not been very tight. I have no idea if crypto will work as a long-term inflation hedge or store of value.

All-in-One Inflation Fighters

This isn't an asset class, so I left it to the end. There are allocation funds that invest in a variety of inflation-proof security types. They're a way to keep your inflation hedges from getting out of hand.

I remember a friend who used to go to the racetrack. He'd bet $20 on a horse to win and then bet $25 on "hedges." That's not the right proportion for hedges. I mentioned at the beginning that inflation is just one of many risks, and it doesn't make sense to go 100% defense. Buying an all-in-one inflation fighter is a good way to keep your hedges in control.

We like Pimco Inflation Response Multi-Asset PZRMX for its well-managed portfolio of TIPS, commodities, emerging-markets bonds in local currencies, real estate, and gold. The fund is up about 11% this year as some of those inflation plays are working.

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