On Inflation and Portfolios, Think Ahead—Not Behind

As US inflation journeyed toward its nearly 40-year high of 6.8% y/y in November, seemingly the entire country has focused on higher grocery bills and the pain at the pump. Now another conundrum is surfacing in headlines: What can people do to keep their savings from losing purchasing power? As Wall Street Journal columnist Jason Zweig’s latest piece highlighted, some are flocking to a complex stock fund that boasts 7% yields, with little regard for how that payout is generated (spoiler alert: it isn’t pretty^[i]) and the risk of loss magnified by the fund’s leverage. Others tout niche government savings bonds limited to relatively small sums, inflation-linked Treasurys, high-dividend stocks and other high-yielding securities—some fringe, some mainstream. We could poke holes in any and all of these, but we think there is a deeper issue to address: the fundamental flaw of basing forward-looking investment decisions on backward-looking information.

For folks frustrated at seeing inflation erode their cash reserves, emergency funds and perhaps even the fixed income 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 savings accounts paying around half a percent and even 30-year US Treasurys a paltry 1.81%.^[ii] Yet we see two problems at work—one practical, one philosophical. The practical flaw is that none of these alleged hedges are quite as magical as some proponents allege. US Treasury Inflation-Protected Securities (TIPS) have basically zero default risk, but their yields are negative across the entire TIPS yield curve. That doesn’t mean you pay to own them, but it does mean you are buying at a premium, and the inflation-adjusted interest and principal payments may not be enough to offset that. Inflation-linked savings bonds (I-bonds), meanwhile, are generally limited to $10,000 in annual purchases per citizen, have lock-up periods and carry early redemption penalties—which runs counter to the purpose of an emergency fund. 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.

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. Arguably, if you owned a diverse portfolio of stocks over the past year, strongly positive 2021 returns already hedged you against that inflation plus quite a bit.

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 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, strip away the emotions that accompany inflation and think of this as you would any other stock market trend or alleged risk. Markets are forward-looking indicators—they move ahead of widely expected economic developments. They also aren’t serially correlated, so 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 or selling a troubled country or company’s bond a week before debt restructuring talks are due to begin. Getting over the recent past and looking forward—to probabilities, not possibilities—is always the right move.

Is it possible you might need something to hedge against 7% inflation over the next year or two? We guess—anything is possible. But probable? No, not from our vantage point. For one, as the recent past illustrates, high inflation doesn’t auto-kill bull markets. Also, as we have shown in more detail in our past coverage, the issues fueling this summer and autumn’s inflation appear to be slowly working themselves out. Oil production is up, sea freight rates are easing and factory output is recovering. Companies are moving more small goods by air instead of the ocean. Multiple automakers report semiconductor shortages are easing. None of this necessarily points to falling prices, but it does suggest 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, reacting is rarely a winning tactic. 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.