As inflation rages and the Federal Reserve steps up interest rates, many of our investment clients are inquiring about increasing their bond positions. Higher yields can look attractive, especially in an uncertain and extremely volatile equities market. But bond buyers beware. The Fed promises several more interest rate hikes in the coming quarters, and due to supply chain issues, including those related to the war in Ukraine, inflation could continue to be a concern for some time. Or, quite possibly, they may not. As in the past, the Fed has indicated that they tend to be data dependent in their decision-making process, and that could influence their rate hikes, or lack thereof, going forward.
Yes, bond yields are increasing, but in terms of real returns, bonds are attractive only when inflation starts coming down. If you have a bond—I-bonds with their higher rates have been getting a great deal of attention lately—that pays 6 percent, but inflation is tracking at 9 percent, you’re losing 3 percent in real returns. As of April 21, 2022, the U.S. Aggregate Bond Index was down 9.3 percent while the S&P 500 index for the year was down about 7 percent.
That means that bonds have been selling off at lower than face value, or principal. For example: Bill buys a 10-year corporate bond with a 4 percent rate of return. Three years later, Bill decides to sell the bond, but interest rates have risen and 10-year bonds are now paying 6 percent. Bill will have to take a deep discount on principal to sell his 4 percent bond. However, if Bill is a long-term investor, and as inflation settles down over time, Bill can hold until maturity and receive par value for his bond, and not lose his initial investment.
Inflation fighting equities
There are some equity sectors that typically do well during inflationary times. Energy companies pay relatively larger dividends and energy products remain in high demand as the Russian invasion of Ukraine and the resulting bans on Russian oil and gas have rendered the products and therefore their prices dearer. Financials tend to do well in an inflationary environment because the cost of borrowing goes up, leading to bigger bank profits.
Inflation and the war in Ukraine have also strained the supply of commodities, as both Russia and Ukraine are major commodity exporters. As has the Omicron-related shutdown in major Shanghai, a major exporter. Commodity-driven pricing also contributes to the market performance of materials companies, and of industrials, where costs are also being affected by surging real estate prices. Industrial stocks, however, can be stressed by higher input and labor costs.
Value stocks, like energy companies, tend to do better than growth stocks in an inflationary environment because they pay relatively high dividends. Gold is also a diversifier, but only if the dollar loses value against other currencies; currently, the dollar remains strong as inflation soars even higher overseas than in the U.S.
Stay your course
Real inflation, that is, the inflation we feel daily at the gas pump and the grocery store, is even higher than the published rate. Grocery prices are up 20 and 25 percent on many products, and reflected in the packaging strategies of producers. Your 32-ounce bag of coffee is now more likely to be a 28-ounce bag; packages shrink as prices increase.
So how should you adjust your portfolio to accommodate an environment marked by inflation and demand outreaching supply? As is usually the case, the best course is to remain on course. If inflation calms and the restrictions are lifted in Shanghai, the markets could settle quickly. On the other hand, with the Fed announcing the possibility of hiking rates in June by three-quarters of a percent, and continued limited supply and heavy demand, inflation could rage on and bond yields could go even higher.
You might rethink some parts of your 60-40 diversification, moving into more value-oriented equities from growth, and switching out some corporate bonds for junk bonds and their higher interest rates. But overall, the best strategy is still to tailor your investments, including bonds, to your individual financial goals and your long-term financial plan.
For more information or to talk with an HBKS wealth advisor, call us at (716) 672-7800; or you can email me at lfiorella@hbkswealth.com.
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