TRICKS OF THE TRADE
Investing During an Inflation
Are you afraid to look at your investment statements? The S&P 500 was recently down almost 20%, while the US aggregate bond market index was down by about 8%, its worst quarter for bonds in 42 years. This is rather unusual, as stocks and bonds tend to behave the opposite of each other. However, there are times when an event causes downward pressure to both, which has been the case this year. While there are other factors impacting the markets, the main culprit has been inflation. In this article, we will look at some asset classes that could be used during periods of high inflation.
In March and April, inflation exceeded 8%, reaching a 40-year high. As a direct result, the Federal Reserve has begun the process of raising interest rates in an attempt to bring inflation down to its targeted rate of 2-3%. This economic environment of inflation and rising interest rates has adverse effects on both the stock and bond markets. As the Fed raises interest rates, the value of bonds falls. Inflation and rising interest rates put pressure on corporate earnings, so stock prices fall, too. For the typical 60/40 (60% stocks and 40% bonds) portfolio, there have been few places to hide, as the 60/40 portfolio has delivered one of its worst starts since World War II. So, what are some techniques to limit investment downside during a rising interest rate environment?
Six Investment Asset Classes
There are six investment asset classes that tend to be more resilient during an inflationary / rising interest rate environment. These are:
- Short-Term Bonds: The longer the term of a bond, the more sensitive it is to interest rate changes. Thus, bond investors should reduce their exposure to long-term bonds.
- High-Yield Bonds: These bonds are typically less sensitive to rising interest rates. However, high-yield bonds have lower credit quality, carry greater investment risk, and often behave similarly to stock investments.
- Floating Rate Bonds: These bonds have interest rates that fluctuate along with the interest rate environment (much like a Home Equity Line of Credit). Thus, these bond values are not as interest-rate sensitive. However, like high-yield bonds, floating-rate bonds typically invest in lower-quality credit and carry greater investment risk.
- Short-Selling Treasury Bonds: Short-selling Treasury bonds means investors sell Treasury bonds they don’t even own because they believe that bond prices will fall. This is considered speculative, extremely risky, and is typically used only by very experienced institutional investors.
- Treasury Inflation-Protected Securities (TIPS): TIPS are government bonds that can help protect investors from inflation, as the value of TIPS will increase with inflation.
- Commodities: Commodities are goods used in commerce such as gold, oil, copper, lumber, etc., and these typically have a positive correlation with inflation. Thus, as inflation goes up, commodity prices typically rise in value. However, this asset class is typically very volatile and considered to be a risky investment.
Investing During Inflation
In conclusion, we all know the start of 2022 hasn’t been kind to investors and we understand that investing in an inflationary environment can be tricky. Simply put, there is no crystal ball that will tell you the market’s direction, but we believe these asset classes can help investors weather this inflationary storm.