Advisors routinely counsel clients that equities are a hedge against inflation. For years, investors didn’t have to concern themselves much with that advice, as the core inflation rate remained fairly muted while equity markets raced higher.
That may be changing.
Companies throughout various S&P sectors and industries are increasing prices for goods and services.
According to a June report from the U.S. Bureau of Labor Statistics, the “all items index,” part of the bureau’s consumer price index, rose 5% between May 2020 and May 2021. That’s the largest one-year gain since the time period ending in August 2008.
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Inflation Concerns
That increase is sparking concern that the U.S. and the rest of the world may be on track for a repeat of the 1970s, when the rate of inflation climbed to 13.5% by 1980.
Although that kind of scenario appears to be in the worst-case category, advisors say clients are asking about the potential for inflation to chip away at their retirement spending power.
Misty Lynch, a financial advisor at Beck Bode in Dedham, Massachusetts, says clients often feel that fixed income is a safer option despite the proven track record of equities outpacing inflation.
“My job is to help my clients stick to the plan, and that means staying in the market long-term,” she says.
While a move to cash or bonds may feel prudent, it can result in low returns. Lynch notes that some investors who move their portfolio holdings out of equities, with the intention of getting back in when the environment feels better, fail to get back into stocks in a timely fashion.
“Market conditions like volatility and inflation are very normal,” she adds. “Having a financial plan that includes investing for growth of income is best to prepare for whatever comes our way.”
She cautions against becoming complacent with any type of economic condition. For example, she believes investors should factor in potential deflationary impacts of technology, as goods are produced more efficiently and at lower cost.
“This doesn’t mean your dollars will stretch further, and we will all be better off, though,” she says. “I still talk to my clients about the increasing costs they will need to prepare for as we live longer.”
Those costs include health care, housing and the growing levels of debt Americans are carrying into retirement.
[Read: Alternatives to the 60/40 Portfolio.]
Keeping Inflation in Perspective
Kevin Simpson, founder and portfolio manager at Capital Wealth Planning in Naples, Florida, says it’s important for clients to keep the current bout of inflation in perspective.
“A little inflation isn’t a bad thing and neither is the pop we’re seeing as we reopen an economy from a global pandemic,” he says. “I’d be more concerned if we weren’t seeing any inflation.”
Simpson notes that an inflation rate of 2% or 3% is good for corporate earnings, which boost stock prices.
“What we don’t want is runaway inflation or high interest rates. I’m old enough to remember gas lines and 15%-plus interest rates on mortgages. I don’t see us heading there, and that’s a good thing,” Simpson says.
Simpson also recommends taking advantage of market volatility through tactical covered calls.
“When writing a covered call, you are selling someone else the right to purchase a stock that you own for a price higher than it is trading at today for a limited window of time,” he explains. “We tend to write calls 30 days out, and the buyer pays us a premium that we keep, whether the underlying stock goes up, down or sideways.”
That modest premium serves as a downside hedge that can help smooth an investor’s return.
Planning for Inflation
Stephanie McCullough, founder and CEO of Sofia Financial in Berwyn, Pennsylvania, says her ongoing financial planning process takes inflation into account.
“It’s amazing, when you’re looking at a 25- or 30-year retirement period, the difference between assuming 2.5% inflation and 3.5%,” she says. “Compounded over time, that seemingly slight difference has huge implications for whether a client has enough to retire.”
McCullough’s clients have been asking about how their outstanding debt will be affected by inflation.
“For folks with adjustable-rate loans — mortgages, home equity lines, credit card debt — we’re advising to lock in today’s low rates if they can,” she says.
“For those with fixed-rate debt, like a mortgage or a car loan, we often try to talk clients out of paying those loans down,” she adds. “That money could be much more effectively used building up your assets to help be a buffer for raising prices.”
[Read: Why Financial Advisors Should Watch the Bond Market.]
Current Levels May Be Transitory
Bill Hornbarger, chief investment officer at Benjamin F. Edwards in St. Louis, expects inflation to be higher, but not rising to 1970s levels. He believes the current data, which show what he calls “uncomfortably high” inflation levels, are transitory, as the Federal Reserve has stated.
He says factors contributing to those levels include “supply chain issues as a result of COVID, easy comparisons now to a period last year of almost no economic activity and a lot of pent-up demand. Those pressures will recede over time.”
Hornbarger’s asset allocation models for client accounts have an outlook of seven to 10 years.
Based on several factors, including slightly higher, but not significant, inflation, Hornbarger’s firm increased its equity holdings within the allocations. Within that increase, there is also a slight tilt toward international equities.
The firm also bumped up its allocation to real estate, an asset class Hornbarger says should see some benefits in the form of rents.
“With our outlook of moderate inflation — but higher than the past decade or so — we think that will ultimately be reflected in earnings, which will provide a tail wind for equities,” he says.
On the fixed-income side, he’s recommending strategic allocations to high-yield and emerging-market debt to diversify away from rising interest rate risk.
McCullough emphasizes a key tenet of financial planning: Investors should consider the likelihood of inflation, even if it’s a small increase, before it occurs. That means doing a deep dive into spending to understand what’s essential versus nice to have.
“Have a plan in place before a crisis so you know,” she says. “And if you’re part of a couple or family, you’ve already agreed what gets cut back if things get tight.”
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Advisors Urge Clients to Plan Ahead for Possibility of Inflation originally appeared on usnews.com
