The below article is a synopsis of a recent discussion between Morningstar's director of personal finance, Christine Benz, and Morningstar Investment Services' Investment Manager Marta Norton.
Inflation-linked bonds and similarly-named bond funds may jump to mind when you think of ways to try to keep your portfolio in check with inflation, but there are myriad other tools at your disposal, each of which comes with its own merits and caveats.
Commodities
When it comes to looking at commodities, there are really three sources of return: The spot price, the interest you're getting on your collateral, and then also the roll yield, which is affected by contango. The idea of contango means that you're selling the cheaper contract and buying tomorrow's more expensive contract—something that Morningstar Investment Services’ philosophy for inflation-concerned investors would argue against doing. Such a manoeuvre can be negative in the short run or in certain market environments for commodity futures. At the same time, looking at natural-resource stocks, these are companies that are in the business of the commodities, and they can make money and capitalise on those commodities, but you also need to be aware that you’re getting that equity market exposure here and you could make some bad stock picks.
“We would argue that commodities have a role, and we would use commodity future funds for that stake. At the same time, we would add natural-resource stocks to the portfolio, and that would require us trimming that commodity stake in the futures funds and trimming global stocks and kind of treating them as a hybrid between those two asset classes,” Norton says.
Real Estate
Norton adds that real estate is commonly brought up when people think of an inflation protector. Morningstar Investment Services’ research suggests that it can be an effective hedge, but there are also factors that can reduce its effectiveness. When you think of REITs (real estate investment trusts), they're collecting the rents from apartments or commercial properties in general and often those rents can tick up during inflation periods. So that's where their value lies.
But at the same time, high vacancy rates or valuations can reduce the effectiveness of that hedge. Morningstar Investment Services’ research hasn’t found it to be a top contributor to inflation protection, but it’s certainly something that Norton thinks investors traditionally look to, and it's something that she thinks can add value, but just at a smaller margin than maybe people assume. Global is the way to go, she adds—get diversification by broadening your portfolio.
But what about some of the other inflation-hedging tools that are a little off the beaten track? Norton says running correlation figures across a wide variety of asset classes, pops up a number of asset classes that appear impressively related to the consumer price index movements, probably even more so than inflation-linked government bonds in certain periods.
High-Yield Bonds
High-yield bonds is one of them. They have fatter coupon payments so they’re less affected by inflation and interest rates. High-yield bonds can actually experience a fundamental improvement during inflation periods because the value of the outstanding debt shrinks as inflation picks up. Convertible bonds would also fall into this category of attractive inflation-hedging asset classes that can experience fundamental improvement in inflation period.
Some of these asset classes mentioned, namely high-yield, could be considered to be a little richly valued at present. So should potential investors try to be tactical about using them? Is it wise to load up on them when they’re looking cheap and pull back a little bit when they’re relatively more expensive? Norton says that when it comes to being tactically there are two ways to go about it. The first is to be tactical by going all-in and all-out, and the second is being underweight and overweight. Morningstar Investment Services would favour the latter approach, she says, because when you think of inflation protection what you’re really thinking about is a form of insurance. Just as most people wouldn’t try to be tactical with their flood insurance, i.e. trying to buy in at ‘just the right time’, they should try to buy inflation protection at ‘just the right time’ either. “I don’t think it’s an easy call for anyone to make--timing inflation--and you also might find yourself paying through the nose once it’s at the threshold.”
For someone who’s nervous about inflation protection, maybe a retiree who is getting close to tapping into his assets, this can be a time to layer on some inflation protection and leave it there. You can still be tactical: you might not favour inflation-linked government bonds due to their extremely low yields, but there is a big difference between being underweight and completely absent altogether.
Go Global
Norton suggests not just being worried about inflation because there are other risks that go hand-in-hand with inflation, such as rising interest rates or sterling coming under pressure. “When we think of inflation protection, we actually think globally, not just in real estate, but also in global stocks, global bonds, emerging-market currency—ways to loosen a portfolio’s ties to the portfolio’s domestic currency.” When looking at global stocks, Norton also points out that not all stocks are created equally—investors concerned about inflation should be thinking about those companies and industries that really have pricing power and can pass along higher input prices to their consumers. If you’re not thinking globally, you’re losing investment opportunities.
The information, data, analyses, and opinions presented herein do not constitute investment advice; are provided solely for informational purposes and therefore are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Diversification does not ensure a profit or protect against a loss in a declining market. Past performance is not indicative and not a guarantee of future results.
Morningstar Investment Services is a registered investment advisor and wholly owned subsidiary of Morningstar, Inc.
