Concerned About Inflation? Learn How Diversification Acts as a Hedge

The success of the COVID vaccines has spurred growth expectations, as headlines have turned from fears of a double-dip recession to concerns that the world economy could overheat. Re-openings across industries combined with unprecedented monetary and fiscal stimulus have caused many to wonder if inflation, largely dormant for the last thirty years, could make a return, and how their investments would perform in a rising inflation environment. Below, we offer a brief primer on how different asset classes can protect your portfolio against inflation.

Equities

Stocks remain investors’ best source of long-term returns, even when adjusted for inflation. During inflationary periods, companies generally pass their price increases along to the consumers which erodes purchasing power while maintaining profit margins. As always, keeping an appropriate time horizon is important for equity investing. Stocks can be volatile in the short-term, but over the vast majority or rolling five-year periods, they produce a positive return. While global markets are increasingly intertwined, international and emerging market equities in particular can provide a good hedge against a falling US dollar.

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Fixed Income 

Rising inflation is typically accompanied by higher interest rates, which are detrimental to holders of long-term fixed-rate bonds. As such, shorter duration fixed income outperforms in periods of rising rates, as investors have the option to reinvest maturing bonds at higher yields. Lower credit quality also provides a buffer against rising rates, as areas such as high yield and floating rate debt benefit from the improved economic prospects often associated with inflationary regimes.

Commodities/Real Assets

When paper currencies become less valuable due to inflation, hard assets such as gold and real estate – items that cannot be printed by central banks – tend to outperform. Higher oil prices are also a staple of above-average inflation, which would benefit energy infrastructure assets.

Diversification

Above all, the simple axiom of investing holds regardless of the inflation outlook: don’t put all your eggs in one basket. No matter your views on inflation, maintaining a diversified portfolio and keeping with your long-term strategy will win out in the long run.