On Inflation and Portfolios, Think Ahead—Not Behind

As inflation rates across the UK, US and Europe have journeyed higher this summer and autumn, most coverage in financial publications we follow have focused on higher grocery bills and petrol prices. Now another conundrum is surfacing in headlines: What can people do to keep their savings from losing purchasing power? Commentators across the developed world have offered a number of potential solutions, including inflation-linked gilts, high-dividend stocks and other high-yielding securities—some fringe, some mainstream. In our view, none of these is a panacea, but we think there is also a deeper issue to address: the fundamental flaw of basing forward-looking investment decisions on backward-looking information.

For people frustrated at seeing inflation erode their cash reserves, emergency funds and perhaps even the fixed interest portions of their portfolio, we understand the desire for a shield. We also understand why people might feel the urge to get creative, what with current accounts paying a pittance and even 50-year gilts yielding a paltry 0.69%.^[i] Yet we see two problems at work—one practical, one philosophical. The practical flaw is that, in our view, none of these alleged hedges are quite as magical as some proponents allege. UK index-linked gilts, whose interest and principal payments fluctuate with the retail price index (a government-produced measure of inflation), have basically zero default risk, but their yields are negative: The ICE Bank of America UK Inflation-Linked Gilt Index currently has an aggregate yield of -2.77%.^[ii] That doesn’t mean you pay to own index-linked gilts, but we think it does mean you are buying at a premium, and the inflation-adjusted interest and principal payments may not be enough to offset that.

High-dividend stocks, meanwhile, offer return of investment rather than return on investment—their share price falls by the amount of every dividend issued. We like dividends just fine, as they are part of stocks’ total return, but they are technically zero-sum if you don’t reinvest them, not an inflation hedge. (Total return refers to price appreciation plus the return on reinvested dividends.) Beyond that, whilst some bonds have significantly higher yields, in our view, they come with much higher default risk, which may run counter to savers’ goals. Other products may have long lock-up periods with early surrender penalties. In our experience, these conditions are also breeding grounds for financial scams, making caution and due diligence paramount.

Moreover, we think there is a deep fallacy at the heart of the great inflation hedge hunt: trying to position your portfolio to compensate for an inflation rate that represents price increases over the prior 12 months. Those price increases sting, but you can’t go back in time and hedge against them. That ship has sailed, in our view. Arguably, if you owned a globally diversified portfolio of stocks over the past year, strongly positive 2021 returns already hedged you against that inflation plus quite a bit.^[iii]

In our view, what matters is what happens looking forward. What if inflation eases and you are trapped in an illiquid security—or one with high default risk—for no good reason? What if you bought that security at a premium because you traded on what we think is one of the most widely known pieces of information on Earth (the current inflation rate)? What if you let all your core goals and financial needs take a back seat to your inflation fears, but those fears don’t pan out?

To see this more clearly, we suggest stripping away the emotions that can accompany inflation and thinking of this as you would any other stock market trend or alleged risk. Our research shows markets are forward-looking indicators—they move ahead of widely expected economic developments. They also aren’t what statisticians call serially correlated, meaning one day, week, month or year’s movement doesn’t predict the next. Repositioning for fast inflation now could be akin to leaving stocks deep into a bear market (typically a long, deep decline of -20% or worse with a fundamental cause) or selling a troubled country or company’s bond a week before debt restructuring talks (which usually involve default) are due to begin. Getting over the recent past and looking forward—to probabilities, not possibilities—is generally the more beneficial move, in our view.

Is it possible you might need something to hedge against fast inflation over the next year or two? Technically, yes—anything is possible. But probable? We don’t think so. For one, as the recent past illustrates, high inflation doesn’t auto-kill stock bull markets.^[iv] Also, as we have shown in more detail in our past coverage, the issues that our research shows fuelled this summer and autumn’s inflation appear to be slowly working themselves out. US oil production is up, sea freight rates are easing and factory output is recovering in many large economies.^[v] Many companies are reportedly moving more small goods by air instead of the ocean. Multiple automakers report semiconductor shortages are easing.^[vi] None of this necessarily points to falling prices, but it does suggest to us that this year’s big increases are mostly unlikely to repeat, likely negating the need for a big inflation hedge over the foreseeable future.

When making portfolio decisions, we think reacting is rarely a winning tactic. A psychological tendency called recency bias makes humans believe the future will resemble what just happened, but life—and investing—rarely works like that. Looking forward and weighing reasonable probabilities, in our view, is a much sounder approach.