Inflation Coupled with Geopolitical Uncertainty

There has never been a time in history in which investors were not distracted or influenced by geopolitical uncertainty, macro environment risks, or pandemic; but how about the combination of all three?  With economies around the world already feeling the effects of soaring inflation, the timing of Russia’s invasion of Ukraine could not have occurred at a worse time.  Globally, supply chains are sluggishly normalizing from bottlenecks induced by the pandemic and with rising input costs this will only push rising prices into overdrive.  Essentially, the Russia and Ukraine conflict is pouring fuel onto an already well-kindled fire and with a full tank it is easy for things to get out of hand.  While energy prices may rise, there are ways it can be offset to limit the potential economic disruptions.  The U.S appears close to a nuclear deal with Iran which would bring much needed supplies to the market at a critical time.  Despite these recent developments, investors are swiftly climbing the wall of worry and succumbing to their fears instead of using history to act as a guide for the current risks. 

While the situation is fluid, history shows the equity market impact can play out in short order even if the conflict lingers.  When examining major geopolitical events over the past sixty years, equity markets often react negatively to the initial news and the selloffs are typically short-lived and returns over the following six to twelve months periods are largely in line with long-term averages.  On average, stocks returned 5% in the six months following this type of dramatic event and 9% after the event. 

With the rise of geopolitical uncertainty, inflation is a valid concern, but can be properly navigated within your portfolio.  With inflation at the highest levels since 1982, it has real consequences for the economy as companies must pay more for employees and raw materials.  Ultimately, elevated inflation will tip the hand of the federal reserve as one of their mandates is keeping inflation at a stable level.  In our view, we expect inflation to be elevated for the remainder of the year but see a path for price growth to decelerate over the summer.  The question to ask yourself is how should you safeguard your portfolio while the Federal Reserve delicately combats inflation by increasing interest rates?

One of the more straightforward ways to protect against inflation is with Treasury Inflation-Protected Securities (TIPS), which are a type of U.S. Treasury security whose principal value is indexed to the rate of inflation.  Essentially, when inflation increases the TIPS’ principal value is adjusted up, but if there is deflation then the principal value is adjusted lower.  While TIPS have fixed coupon rates, their coupon payment will vary depending on their principal value and the change in the rate of inflation.  It is important to note that TIPS are considerably more volatile than cash, especially during market corrections.  While TIPS are worth considering as an inflation hedge, there is a risk they could underperform traditional U.S. Treasuries if the actual inflation does not meet the lofty expectations.  Inflation-resistant fixed income investments include Treasury Inflation-Protected Securities (TIPS), shorter duration bonds, high-yield bonds, and international bonds. In an environment like today where such inflation protection is valued, Treasury Inflation-Protected Securities do not necessarily provide that type of protection on an immediate basis. However, if the market is wrong on where inflation is headed, TIPs can help protect your portfolio from inflation shocks.          

Today, dividends matter more than ever.  The value side of the market is finally garnering attention from investors as they are beginning to focus on companies that have been overlooked for the better part of the last decade.  These fundamentally valued companies appear quite compelling due to their pricing power, are relatively inexpensive and offer robust dividend payouts.  Keep in mind that since 1930 dividends have accounted for roughly 40% of the overall return for the stock market.  During periods of high inflation, companies that can increase their dividends will not only outperform the broader market but will reduce the volatility of a stock’s total return.  Dividends can be reinvested throughout the year thus allowing investors to take advantage of price declines in the stock.  During challenging times these fundamentally valued companies provide investors with reassurance and peace of mind, since their profitability and ability to generate excess free cash flow will remain intact.  Ideally, you want to invest in a company before the dividend growth is priced in.  We expect companies that cut their dividends in 2020 to reinitiate and increase them as the economy and their businesses recover.

Inflation is always important from a financial planning standpoint because we need to take into consideration your long-term financial objectives relative to your purchasing power.  Ultimately, the higher the rate of inflation, the higher your return will need to be to maintain the purchasing power of your assets.  For instance, if there is an increase in the average annual inflation rate then to keep up with inflation an investor would need to adjust their portfolio to target a return of at least the increased rate of inflation to maintain their purchasing power.  Staying ahead of inflation is a key component of investing and financial planning since it is the only way to passively increase your future purchasing power.  The best way to achieve this objective is with a balanced portfolio that is diversified across asset classes and contains inflation-resistant investments.  This will not only enhance your return but will reduce the overall risk and volatility of the portfolio.