With inflation in the headlines, some might be wondering about its impact on their portfolio or overall financial situation.

First, we shouldn’t accept the assumption that “high inflation is here to stay,” despite how prevalent that assertion seems to be these days.  We at Geometric don’t make predictions about inflation (or anything else), but the market does every day.  The market’s prediction for long-term inflation can be observed as the difference between 20-year nominal treasury bond yields and 20-year Treasury Inflation-Protected Securities (or TIPS).  That spread is currently 2.7%[1].  Even if it feels like inflation is going to be higher than that, it’s generally unwise to trust our instincts over the collective wisdom of millions of market participants.

Still, an extended period of high inflation is always a possibility (now and at any other moment in time), so it’s worth addressing what that would mean for your portfolios and other assets.

Geometric’s client portfolios are comprised of stocks (US, International, and REITs) and bonds (both nominal bonds that do not adjust for inflation and TIPS that do)[2], all owned via low-cost funds/ETFs.  Stocks have historically been a good long-term hedge against inflation, because companies can typically adjust their prices such that their profitability is protected.  TIPS are of course a direct hedge against inflation.  Therefore, the only portion of our client portfolios that remain truly exposed to inflation are nominal bonds.

(One could argue that an investor’s entire bond allocation should be invested in TIPS so as to not have any element of the portfolio fully exposed to inflation, but there would be a long-term cost to doing so.  All else equal, TIPS have a lower yield than nominal bonds – this is the cost of the “insurance” of inflation protection – and fully insuring one’s bond portfolio against inflation can be very expensive, especially for younger investors.[3])  

Given the recent spike in inflation, should we temporarily shift some or all of our nominal bond holdings to TIPS?  Unfortunately, since the market’s expectation for inflation is already priced into both nominal bonds and TIPS, one could only profit from such a trade if inflation ends up being higher than the market’s expectation for inflation, and again, it’s generally unwise to bet against the market.

While gold and other commodities are sometimes thought of as good inflation hedges, our view is that they are not.  Commodities do not meet our criteria for an investable asset class.  A gold bar doesn’t produce any cash flows, so owning it is simply a bet on price appreciation (which for us makes it a “speculation” rather than an “investment”).  Any utility derived from owning gold during inflationary times is outweighed by the drag on long-term expected returns.

How about inflation’s impact on the other assets on your balance sheet?  Aside from their investment portfolios, our clients’ two main financial assets tend to be their house(s) and their cash.  Real estate tends to be highly correlated with inflation, so that (often sizable) line item should be well-protected.  Cash, of course, is not protected against inflation, which partially explains why people should maintain only the amount of cash necessary to cover their short-term needs and emergency reserve.

There is one other important asset to address: human capital.  Because wages also tend to adjust with inflation, for those whose present value of future earnings still exceeds the present value of future expenses – true for many or most of Geometric’s clients – inflation might actually be beneficial.  This is especially true when certain meaningful expenses – particularly one’s mortgage payments – are either entirely fixed or fixed for a period of time (i.e., those with adjustable-rate mortgages).

While we make no predictions about where inflation is headed in the short-term, regardless of how it plays out, our clients should feel comfortable that their portfolios and balance sheets are well-positioned.

[1] Calculated as the difference between the daily treasury par nominal and real yield curve rates as of May 23rd.  Source: Resource Center | U.S. Department of the Treasury

[2] Each client’s portfolio asset class composition and allocation are discussed in relation to their personal risk profile and balance sheet.  As a result, there are clients who may not own assets in every sub-category (e.g., REITs)

[3] Older investors, and especially retirees whose human capital has been fully depleted but still have plenty of expenses ahead of them, are more harmed by inflation and should therefore be more willing to insure against its risks.  As our clients approach retirement, we increase the proportion of their bond portfolios invested in TIPS.