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Why Your Retirement Portfolio Needs Inflation Hedges

Published on: Apr 24 2022

Are we about to face another period of stagflation like the one in the 1970s?

Before Russia invaded Ukraine, the economy already was facing a series of supply and demand shocks that pushed inflation to its highest levels in 40 years.

The invasion has caused new supply shocks, reducing global supplies of oil, natural gas, wheat and other widely used commodities.

Inflation is likely to remain elevated because of the new supply shocks and the slow response of the Federal Reserve to the inflation that has been building for about two years.

But the new supply shocks also have the potential to reduce economic growth as the oil supply shocks did in the 1970s.

The parallels between the 1970s and the 2020s aren’t perfect, but they’re close enough that investors need to be aware of them and prepare for the possibility of high inflation and slow economic growth.

In a “stagflationary” environment, stocks and bonds won’t help achieve your rate of return goals or protect your principal. Stocks and bonds both had extended bear markets during the 1970s stagflation.

Most people are underinvested in inflation hedges because they underperformed during the low inflation of recent decades.

In recent years, I’ve been encouraging investors to increase their holdings of inflation hedges.

Commodity prices react strongly to supply and demand shocks. There were sharp price increases in almost all commodities this year, even before the invasion of Ukraine.

The energy sector is the leader of the stock market indexes, rising more than 30% so far this year.

A broad-based basket of commodities is up more than 20%. Financial assets have been and remain vulnerable. Stocks appreciated far more than the economy grew for years, but especially for the last two to three years.

That kind of imbalance can’t continue indefinitely and is especially unlikely when the central bank is removing liquidity from the economy and raising interest rates.

The Fed’s been behind the curve on inflation. At least part of the delay in fighting inflation was deliberate to avoid tipping the economy into a recession the Fed has few tools to counteract.

Soon, the Fed will have to be more aggressive than the markets anticipate to reduce inflation to an acceptable level. That will take some work, as the inflationary forces now are self-sustaining.

The riskiest assets still are those that benefited the most from the extreme fiscal and monetary stimulus of the last few years.

They already lost a lot of value since their 2022 peaks, yet the policy tightening barely has begun.

Three different types of tightening are in the works.

There’s fiscal tightening, that’s begun as some of the pandemic stimulus programs were allowed to expire.

There could be more fiscal tightening if proposed tax increases go into effect or there are reductions in other spending programs.

Higher interest rates are a form of monetary tightening. While promising higher rates for some time, the Fed delayed its first modest move to March.

Markets are ahead of the Fed. They’ve been pushing rates higher and faster than the Fed. The Fed is going to reduce its balance sheet, withdrawing liquidity from the economy and markets.

That’s known as quantitative tightening, and it hasn’t started. Many investors are betting it won’t take much tightening to curtail inflation, so financial assets and the economy won’t be hurt much before the tightening stops.

That looks like a risky bet with little or no margin of safety. It is going to take a lot to stop the forces propelling today’s inflation.

Instead of focusing on the investments that did best before 2022, be sure your portfolio has additional assets, such as inflation hedges and value stocks.

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