Inflation can have a major impact on performance, but if you know the early “tells” of rising inflation and build hedging, or protective, strategies into your portfolio, you’ll be able to handle the hit. Here’s how.
What is inflation—and how can investors tell it’s coming?
Simply put, inflation is when the average level of prices goes up, and as a result people are able to purchase fewer goods and services for the same amount of money.
The most common way to measure inflation, the Consumer Price Index (CPI), is projected to be choppy for the remainder of 2021 and into 2022, as the economy recovers from COVID lows and market disruptions. However, according to research from BMO Economics, there are signs that other factors not captured in the basket-of-goods measure that CPI represents may either impact inflation, or show that it’s on the way up.
One of these factors is the supply chain, says Alfred Lee, ETF Portfolio Manager at BMO Global Asset Management. For example, “We’ve seen lumber prices race ahead since the end of March last year,’” Lee notes on the BMO ETF Deep Dive podcast. Supply chain disruptions as mills were forced to close, combined with demand from home renovations as everyone stayed put, disrupted market prices. “Producers no longer have to eat those costs,” he continues. “You can rest assured that those higher prices will be passed on to the end consumer, which will eventually be captured in CPI.”
Another sign that inflation may be on the horizon: A high breakeven rate, which, Lee explains, is the difference in yield between a nominal bond and a Treasury Inflation Protected Security (TIPS), which is a bond that’s inflation-protected by the U.S. Treasury. “The higher the breakeven rate, the higher the market anticipates inflation to be,” he explains.
Using fixed-income assets to hedge against inflation
Inflation is a risk to bonds, since in real terms it eats into the investment principal. To show what that looks like, Lee gives the example of investing in a bond with a 2% coupon. If inflation stays at 3%, your real return over the life of the bond is actually -1%, reducing your future purchasing power.
But that doesn’t mean you should avoid bonds during inflationary periods. Government bonds do offer security (offsetting equity market risk), so if you’d like to include bonds in your portfolio, you could get into something like BMO’s recently launched Short-Term US TIPS Index ETF (ZTIP). Because it has a shorter duration, it’s less volatile than bonds with longer terms to maturity.
Real return bonds are another investing option that’ll help keep you on track in a high-inflation environment; they’re Government of Canada bonds with a par value that’s adjusted for inflation. While this portfolio includes longer-date bonds, you may want to go with something like BMO’s Real Return Bond Index ETF (ZRR). Because this ETF carries a longer duration, it’s best suited to hedge the long-duration portion of an investor’s portfolio.
But even if inflation is in play, Lee cautions against getting rid of all regular bonds. “Traditional bonds still play a very important role in terms of portfolio construction because they help your portfolio mitigate a lot of that equity-market volatility,” he explains. It might be a good opportunity to review your equity–bond mix, keeping in mind your risk tolerance.
Using equities, gold and base metals to hedge against inflation
Equities and commodities can help shore up your portfolio against inflation.
One of the options is infrastructure. Because stock in these companies usually represents hard assets, like cell phone towers, bridges and airports, they generally hold their value in inflationary environments, explains Mckenzie Box, Product Manager for BMO Global Asset Management, in an episode of BMO’s The Markets Insights Webinar. As well, such companies often have long-term government contracts that adjust to inflation to provide them with increased revenue. You can get exposure through BMO’s Global Infrastructure Index ETF (ZGI), which holds a mix of pipelines, electricity and gas, and real estate investment trusts (REITs).
When investors think of hedging against inflation, gold often comes to mind. “Any time currency loses value due to inflation you typically see people move towards a store of value that is tangible—and gold tends to be that default hedge against inflation,” Lee notes. BMO’s Equal Weight Global Gold Index ETF (ZGD) is “a good way to get diversified exposure into large cap gold companies,” he says.
On the flip side, base metals are often overlooked as a hedge against inflation, Lee notes. “The common saying in the markets is that copper has a PhD in economics because it is a good leading indicator in the health of the economy. So that tends to be a good hedge against inflation,” he says. Here, you might try the BMO Equal Weight Global Base Metals Hedged to CAD Index ETF (ZMT).
Get ready for the return of inflation
Although central banks, including the U.S. Federal Reserve and Bank of Canada, use monetary policy (such as interest rates) to guide inflation, it’s likely we’ll all see several inflationary periods in our lifetimes. With some portfolio planning, though, ETF investors can use a variety of strategies to help protect their portfolios through it all.