An increase in the rate of inflation may be at hand. The past year has witnessed a rapid devaluation of the dollar, large budget deficits financed by running the government printing presses overtime and soaring metal and energy prices.
There’s a common belief that equity holdings are a good hedge against an increase in the rate of inflation,
but that may not be true. Instead, consider other portfolio adjustments necessary to cope with higher rates of inflation.
Stock valuations
How should stocks be valued? A stock’s price-to-earnings ratio indicates what investors are willing to pay for $1 of earnings for that company. While the market tends to award higher P/E multiples for stronger expected earnings growth, anticipated risk and market interest rates have the opposite impact.
Interest rates include an adjustment for inflation, so interest rates rise when the rate of inflation increases or is expected to increase. Therefore, holding all other factors constant, an increase in the expected (or actual) rate of inflation should result in lower stock prices.
Try to position your portfolio so that you are less vulnerable to an increase in the rate of inflation. Such actions are often subtle. For example, you could sell or hedge bank stocks which would be hurt by rising rates. Or, you can increase your exposure to foreign currencies and industries where pricing power may be restored by higher inflation.
Of course, buying resource-rich companies is a more obvious choice.
Fixed income holdings
Likewise, consider taking steps in your fixed income portfolios which will protect them against interest rate increases. Some actions to consider are:
1. Purchasing bonds at a premium, which are priced to a call that may not take place. The extension of
the call yields a higher rate than nonpremium bonds pay.
2. Buying mortgage-backed securities which will benefit from a slowdown in mortgage prepayments.
3. Buying TIPS, the inflation indexed bonds which the government has issued.
4. Shortening maturities in your existing portfolio.
5. Buying step-up securities often issued by federal agencies. These bonds must increase their interest rates at certain future dates.
For the last 22 years, stock prices have had a strong tailwind. The usual push from earnings growth has been magnified by the lower benchmark for returns that results in higher price earnings ratios. While a headwind from higher risk-free rate of return may retard stock prices, there are factors that lessen its impact.
Earnings growth will increase the “E” (earnings) in the P/E ratio. Higher inflation may allow some industries greater ability to raise prices. A rise in inflation could encourage consumer buying in order to beat higher prices in the future, and thus increase sales for corporations.
Although there are numerous elements that make one suspect higher inflation rates in the next several years, other economic forces could cancel these out. Indeed, there are some who believe that deflation may result from excess leverage and another economic downturn. We cannot be certain of increased inflation, but we do know that should we experience it, interest rates will rise and price earnings ratios will fall.
The benefits of lower inflation have helped financial assets for more than 20 years. We now face the likely prospect that this benefit has come to an end. The wise investor should make sure his or her assets are not ambushed by a renewal of inflation.
Marc Heilweil is president and CEO of Spectrum Advisory Services Inc. The firm manages approximately $282 million in assets, including the Marathon Value Portfolio mutual fund. Reach him at (770) 393-8725.
