What A Rise In Inflation Means For Your Investment Portfolio | Mar 1, 2021

Analyst Insights

What A Rise In Inflation Means For Your Investment Portfolio

Investors have had roughly a year of extraordinary fiscal and monetary policy which saw low-interest rates and depressed economies. During this time, investment strategies were underpinned by overweighting growth stocks, primarily technology and other companies that benefitted from the work from home mandate. This changed on November 9th, when Pfizer initially announced its vaccine, which offered hope that the virus could be contained and that economies could now begin their recovery from the global pandemic. As a result, in 2021, we have observed investors reposition portfolios; gradually rotating away from the big pandemic winners (like Amazon and Apple) and towards the cyclical stocks, whose overall performance is closely tied to the health of the economy.

However, last week was an indication that markets aren’t quite prepared for a return to normal. In fact, the markets have shown that an increase in inflation is a key economic variable that needs to be monitored. On Thursday, the bond market experienced a larger than anticipated sell-off due to the U.S 10-year Treasury yield climbing higher than 1.6%, its highest level since the COVID-19 global outbreak. Inflation fears are always first seen in the bond market, that’s because it’s the asset class with the most to lose. Inflation erodes the real value of the fixed interest you earn on a bond, as well as the purchasing power of the capital you receive when it matures. However, inflation’s effect is not only limited to the fixed income market, as stock investors are trying to interpret what a rise in bond yields means for borrowing costs and valuations. Last week’s market events were felt globally as indicated by the S&P 500 index which fell 2.5% on Thursday, Japan’s Nikkei which declined by 4%, Hong Kong’s Hang Seng was down by approximately 3.4% and China’s CSI which fell by 2.4%. Why did the bond sell-off affect the equity markets? The more technical reason is that inflation threatens to erode the value of future earnings for those companies which are expected to deliver rising earnings. Inflation expectations also lead to higher interest rates which can affect stocks, as growth companies benefit from a low-rate environment where the borrowing costs today are lower. So what happens next? Yields are expected to continue rising as the global economy continues its recovery, supported mainly by higher levels of fiscal and monetary stimulus and the continued distribution of vaccines globally.

Regarding your portfolio, investors should be wary of riskier assets and revisit the typical 60/40 or risk parity portfolios in an effort to develop a hybrid position in this low-yield environment.

Possible strategies that can be deployed that would maximize one’s returns include:

1. Barbell equities Strategy: We recommend maintaining exposure to growth stocks (technology in particular) while adding exposure to select cyclical stocks (financials, as we have noted in our global outlook, will generally benefit from the steepening yield curve and consumer discretionary will benefit from the fiscal stimulus support to households, particularly as the economic recovery strengthens)

2. Commodities Exposure: Review securities that have exposure to the commodities space, copper, for example, is structurally attractive. Also, since 2019 commodities have been at an almost 25-year valuation low.

3. Alternatives: Alternatives will naturally grow in this environment, precisely because of low bond yields and even (artificially) low equity premium.

Notably, with the risk of inflation rising, the Federal Reserve may have to shift policy sooner than expected, by either reducing bond purchases or even raising rates at some point. This would be negative for stocks. However, we think the Fed is likely to continue jawboning the market into believing that the rebound in growth and inflation can be controlled, before they resort to explicit yield curve control, as the last option.


Written by Jonathan Cook, Investment Strategist

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