Adjusting portfolios for rising inflation

As economists and central bankers begin to view inflation as more than a blip, investors are asking how to adjust portfolios for rising prices and interest rates.

Craig Basinger, chief market strategist with Purpose Investments in Toronto, said the 60/40 portfolio still works and is quite resilient, but it may need some tweaking if inflation persists.

Basinger said investors have been critical of the 60/40 portfolio due to a “growing view” that the bond allocation “encumbers return.”

“That’s because we were in such a low-yield environment,” he said.

The advent of higher inflation, however, will probably lead to higher interest rates. On Oct. 27, the Bank of Canada forecast that annual inflation rates will continue to increase, averaging 4.75% the rest of the year, and 3.40% next year.

“For every uptick in bond yields, your future return actually gets a little bit better,” Basinger said. “Not many asset classes can say that.”

For Basinger, the 60/40 portfolio’s effectiveness in an inflationary environment boils down to determining whether or not recent inflation is transitory.

“I agree we have seen some phenomenal headline numbers on inflation. But we also know that, so far, it has largely been influenced by components of the CPI that have very flexible pricing and are wrestling with disruptions and surprise return of demand — and how fast it’s come back in certain areas,” Basinger said.

He added that inflation is starting to show up in other goods and services, but still mainly in flexibly priced items.

Basinger said if inflation proves more persistent, it will be harder for bonds to hold on to their purchasing power after inflation. “Either bond prices fall (yields rise) to partially offset higher inflation or the purchasing power falls. Neither is a good outcome,” he said.

But bonds still have quality defensive characteristics, Basinger noted, and do well during “risk-off” periods. When there’s a “flight to safety, money flows into bonds —even if the broader long-term trend for yields is moving higher.”

Ben Felix, portfolio manager and head of research and client education with PWL Capital in Ottawa, said he understands investor concern on the fixed income side, but the effect of central bank rate increases depends on the type of bonds investors own.

Thirty-year bonds, for example, will be hit “pretty significantly” by big rate increases, he said. Investors in shorter or intermediate term bonds might see the prices fall, “but what’s going to happen as you continue to receive coupons and principal from the bonds you already own, it’s going to be re-invested into new, higher rates,” he said.

Felix said his firm chooses fixed income of shorter aggregate maturity than the aggregate bond index for its portfolios. Specifically, PWL Capital uses funds from Dimensional Fund Advisors that increase exposure to longer maturities “when the yield curve is upward sloping and decreases when it’s flat or inverted,” he said.

“For clients with advisors, I think this is a good approach,” he said, adding that the funds are not available to DIY investors.

Felix said current inflation expectations are already priced into markets, but unexpected inflation increases could affect asset prices in the short term.

“Even if inflation does end up being higher than expected, that doesn’t necessarily mean the real returns on stocks are going to become negative,” Felix said. “Historically, that’s something that has not tended to happen, even in countries where inflation ends up being extremely high.”

Felix noted extremely high unexpected inflation — greater than 18%, which is far higher than what Canada experienced in the 1980s — is related to negative stock returns, according to the Credit Suisse Global Investment Returns Yearbook 2021, published in March. Moderately high inflation (ranging from about 4.1% to 7.5%), like what the global economy is seeing now, is not.

“In the long-run, real stock returns have outpaced inflation around the world. It’s not clear that low rates are responsible for the recent outperformance of growth stocks,” Felix said.

“Low rates aside, I do think that the expected returns of large-cap growth stocks are low based on their extremely high valuations. It is not clear that inflation or rising rates will be the trigger, but historical instances of extremely large companies with high prices have been followed by low returns.”

Basinger said investors may want to reconsider the types of equities they hold.

“If inflation proves more persistent, equities should do better, but not all equities,” he said. “Value [stocks] should do better than growth [stocks]. Equities that are deemed real assets should do even better. This does [put] the S&P/TSX in a pretty good position given our relative sector weights, especially to the more growth-tilted U.S. market.”

Basinger referenced Purpose’s model portfolio for a balanced investor, in which they’re overweight in cash (holding between 8% to 10%), “slightly overweight” in equities and underweight in bonds.

“That allocation is not solely based on concerns about longer-term inflation. It is based on many factors,” Basinger said.