Rates are high; should I just be invested in cash and bonds? Should I worry about inflation?
Lately, many of our clients have been asking about advice they've received to go all-in on bonds and cash, given the current market situation where interest rates have now stabilized at high levels. As such, we wanted to write something that could help most individual investors right now, tackling inflation, geopolitics, and asset allocation.
Inflation and Interest Rate Hikes
Inflation is a stranger to no one, and we experienced its colossal effect on markets in 2022; however, the key here is that inflation indirectly affected markets. It was the high acceleration and potential stickiness that caused central banks in the developed world to increase rates dramatically. While this increase in rates is what has impacted markets the most in 2022, all the indications now clearly show that interest rates have reached a ceiling and are not expected to go up from here. All indications show that inflation has definitely decelerated and is declining.
However, inflation sticking at higher levels than the 2% target is still a probable reality. Suppose inflation were to stick somewhere at a 5% level without showing an indication of going higher. In that case, the Fed may choose not to raise rates further, considering the same level of current interest rates (the overnight rate is currently 5.33%). Now this reality would not be catastrophic for investments, considering that it is the rise in interest rates that affects asset prices negatively and not inflation on its own. However, if the above were to be the case, you definitely don't want to be holding a portfolio consisting only of bonds.
Although bonds today are a very attractive part of an investment portfolio, your returns from bonds are nominal and fixed from the outset. Therefore, achieving a fixed 6% return per annum over the coming years won’t be as attractive if inflation continues at 5% per annum or higher.
So, what should investors do to hedge such a risk?
The answer is quite simple and falls within owning real assets such as equities. When you own equities, you own direct company ownership and are the rightful owner of the future earnings. These future earnings are definitely not fixed and are dependent on the sales of the company's goods and services; therefore, most equity ownership is inflation-hedged. In a world where inflation is higher, so is earnings growth.
As inflation increases, so do the company’s costs, revenues, and profits. As long-term earnings growth is the primary driver of long-term equity performance, equities benefit on a nominal basis from inflation and are unchanged from a real basis. This was not the case in 2022 because it was combined with significant interest rate hikes, which affects all investment classes that derive future profitability (real estate, equities, and bonds).
Therefore, we strongly recommend holding a balanced portfolio composed of both bonds & equities. Considering the relative current attractiveness of bonds, we’d suggest slightly leaning towards bonds while still owning a large percentage of equities. Given their primary inflation risk, the investor who still invests heavily in bonds without owning equities needs an inflation hedge. In this instance, owning commodities would be a good strategy given that they benefit from an inflationary environment, making them a good addition to a bond-only or bond-focused portfolio.
What is our view on inflation?
Our view is that technological innovation has kept inflation very low for more than a decade and pushed on deflation consistently. We do not think this will change; the pace of technological advancements in both artificial intelligence and the automation of business deployment to reduce cost is significant. We believe this will continue to be a powerful deflationary force.
On the flip side, we also see the risk of higher inflation due to a move away from a more integrated globalized unipolar world (where the US sets all the rules and is very happy with enhanced global trade) to a more segregated, less globalized, multipolar world where countries bring supply chains closer home, are more reluctant to trade with others, and keep involving bureaucracy in economic decision making.
This scenario where inflation could be higher wouldn't lead to economic decline, as there would need to be a lot of capital expenditure and investment to bring production closer to home, which would cause economic growth, inflation, and a demand for more commodities. For this reason, our consensus is that inflation will likely remain lower than it currently is, though with the probability that it stays above the target for a considerable while considering the global geopolitical environment.
- Most investors' objective is long-term wealth preservation with reasonable growth. Therefore, diversify different risks and rely on owning and lending to the global methods of production of goods and services that add value to our collective societies (i.e., owning equities).
- Have a balanced portfolio of both bonds and equities.
- If you are overweight bonds, consider having a small allocation to commodities to hedge your risks.