If Inflation Stays High, What Then?

If inflation stays above the central bank's target of 2%, what should you do with your portfolio?

Yan Barcelo 15 March, 2023 | 2:46AM
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If there’s one issue that global investors are united on, it’s inflation. With it comes the question – what should you do if inflation stays high?

“I agree it’s a possibility that inflation could remain high, but it could also go back to levels that we had previous to 2020,” says Christine Benz, Director of personal planning and retirement planning at Morningstar. She considers that policy makers are quite committed to taming inflation. “The Fed is quite willing to inflict pain on bondholders and the rising rate campaign is not over yet,” she adds.

Mackenzie Investments believes forces are gathering momentum that will exert tremendous pressure on costs and promote a sustained higher rate of inflation. For investors who worry about this issue, the firm has devised a new Inflation-Focused fund that addresses that issue. It is a balanced fund that has the flexibility to adjust to different inflation regimes, explains Benoit Gervais, Senior Vice-President at Mackenzie. Presently, it is structured to address inflation that is high and rising.

Could Inflation Stay High?

Gervais explains that there are secular trends will exert a sustained upward pressure on inflation:

  • Climate Change
  • Onshoring
  • Infrastructure

The first of these forces is the fight against climate change, which will require a vast retooling of the economy to produce cleaner goods. Plus, the energy transition will add carbon prices that will significantly add to costs. Gervais gives the example of aluminum, of which only 25% is produced from renewable energy. The remaining production will need to pay a US$ 100 tax per ton of CO2, which will cause the price of aluminum to increase 50%, from US$2,000 to US$3,000. And that’s just aluminum. Gervais expects such additional costs to be multiplied in other areas.

The other secular force he highlights is onshoring, the result of developed countries reorganizing supply chains. The reasons range from, on the one hand, substandard social and environmental practices in emerging countries, to, on the other, the restructuring just-in-time manufacturing. From 1990 to 2005, imports from China exerted a major disinflationary effect, with prices plateauing up to 2020. But following the COVID-19 pandemic, the reshuffling of globalization has contributed sustained upward pressures on prices.

Infrastructure rebuild constitutes the third force. Gervais identifies a US$ 2 trillion shortfall since 2010 in government infrastructure investment, while much new investment will go into greener projects that could prove more costly.

Morningstar Believes Inflation Will Fall in 2023

Preston Caldwell, the senior U.S. economist for Morningstar Research Services points to ongoing data showing a drop in inflation, along with slowing economic growth, which he thinks will induce the U.S. Fed to pivot to driving interest rates lower. “We expect the Fed to even begin cutting the fed-funds rate before the end of 2023,” he says.

Altogether, the Fed has increased the fed-funds rate by 4.5 percentage points since March 2022. That’s the largest one-year increase since the 1980-81 hiking cycle, when the Fed sought to tame the “Great Inflation” which raged throughout the 1970s. Officially, the Fed is saying that “ongoing increases in the [federal-funds rate] will be appropriate.” Fed Chair Jerome Powell added that he doesn’t see the Fed cutting rates this year.

“However, market expectations as well as our own forecast incorporate a lower path for the fed-funds rate than the Fed projects, including rate cuts before the end of 2023. Our forecast is at 3.75%-4%,” Caldwell says, adding that he expects core inflation to fall much faster and reach about 2% by end of 2023.

“Bond yields across the curve are still much above prepandemic levels, and this is starting to drag on economic growth. Nonetheless, the Fed is eager to keep bond yields from falling too much prematurely, as this could allow the economy to heat back up before the battle against inflation is fully won. This desire helps account for the Fed’s continued hawkish rhetoric, even as we do think the Fed will ultimately pivot to fed-funds rate cuts before the end of this year,” he says.

Caldwell also thinks that once high inflation is quelled for good, the Fed will shift focus to lifting the rate of economic activity to its maximum sustainable level. “Ultimately, this will entail substantial monetary policy loosening compared with current levels, in our view,” he says.

What Are the Four Possible Inflation Outcomes?

Gervais’ new fund identifies four inflation regimes:

  • High & rising,
  • High & declining,
  • Low & declining, and
  • Low & rising.

In a “low and declining” regime, such as the one that dominated since the early 1980s and which presents itself by far as the most favorable to stocks, the typical 60/40 portfolio has outperformed the Mackenzie Inflation Benchmark (which informs the new fund) by approximately five percentage points.

From 1955 to 2022, the “low & declining” regime dominated, occupying 40% of the period; the high & rising regime comes in second at 35%. However, Gervais reminds that before the great shift of 1981, the “high & rising” regime dominated nearly 50% of the time.

In the “high and rising” regime that has set in since 2021, the Mackenzie Inflation Benchmark outperforms the 60-40 portfolio by about three percentage points, Gervais says.

What Does This Mean for Your Portfolio?

In the low & declining regime of the last 40 years, a portfolio had advantage to be equally weighted between bonds and equities. The bond portion contained investment grade corporate bonds, emerging markets high-yield bonds and long-term treasuries. Stocks privileged value, small cap and materials sectors. The leading commodity was oil.

The high & rising portfolio changes most of those components, bonds being underweight and equities, overweight. Gervais and Benz are of a single mind on many pieces of an inflation-focused portfolio. Bonds should be of short duration and “inflation-protected bonds could be part of the equation (real return bonds in Canada),” Benz adds.

On the equity side, Gervais and Benz are in agreement. “Stocks tend to do a good job of out earning the inflation rate, but they are not necessarily a great hedge,” Benz points out. She concedes that in 2022 stocks did not shine in spite of inflation, but then “that was because many factors other than inflation weighed in,” she notes.

Gervais’ model portfolio allots a 53% share to energy and materials. “When inflation rises, the price and demand for metals - industrial and precious metals – increase,” Benz says. If investors are thinking that oil could lose its shine as the key commodity in the energy transition, they might consider a shift to broad commodities: metals, grains and beef,  and maybe even natural gas, Gervais says.

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About Author

Yan Barcelo  is a veteran financial and economic journalist with more than 30 years of experience, Yan writes for many publications in Toronto and in Montreal, including CPA MagazineLes Affaires and Commerce.

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