Inflation Hedges Explored

Contributed by: Nicholas Boguth, CFA®

Our Director of Investments, Angela Palacios, recently wrote about the factors influencing current inflation rates. She shared a helpful chart from JPMorgan and summarized, “you may be surprised to see the strong average performance from varying asset classes in this scenario. Inflation that is reasonable and expected can be a very positive scenario for many asset classes.”

As the debate continues over whether or not inflation is “transitory,” some investors are thinking about how to protect their portfolios from rising inflation.

Most bonds, aside from TIPS, are generally expected to perform poorly if inflation rises. This should make sense as the fixed income stream from a bond investment will deteriorate if inflation rises. To protect against inflation, one might conclude that removing bonds from a portfolio makes sense, but not so fast. Bonds are typically in a diversified portfolio to protect from the more common (and devastating) risk – a stock market decline. Be sure to know how your portfolio’s risk exposure would shift before considering a move away from bonds.

Vanguard recently released some research on the topic of inflation hedging and concluded that commodities were the best asset class to protect from unexpected inflation. While commodities are generally accepted to be pretty good inflation hedges, one major risk of owning them has been on display for the past ten years. Their return stream can look significantly different than stocks’. Admittedly, this has been one of the best decades in history for U.S. stocks and one of the worst for commodities. To demonstrate just how “different” the returns can be, if you would’ve held one of the largest commodity ETFs over the past ten years, you would’ve underperformed the U.S. stock market by almost 400%.

Trailing 10-year performance of two ETFs that represent the U.S. stock market and the broad commodities market. SPY (green line) tracks the S&P 500, and DBC (blue line) tracks a basket of 14 commodities. Total return. Source: koyfin.com.

Some portfolio managers like Ray Dalio or First Eagle portfolio managers, Matthew McLennan and Kimball Brooker, have been long time proponents of gold as a hedge against inflation. Gold can be a powerful diversifier in a portfolio, but has also seen sustained periods of underperformance that may make it hard to hold over the long term. Here’s a similar chart of how a popular Gold ETF has performed over the past ten years compared to the red hot S&P 500.

Trailing 10-year performance of two ETFs that represent the U.S. stock market and the price of Gold. SPY (green line) tracks the S&P 500, and GLD (blue line) tracks the gold spot price. Total return. Source: koyfin.com.

You may even see articles claiming that bitcoin is the best inflation hedge to add to your portfolio. These opinion pieces make some compelling arguments, but it is important to remember that they are just opinion pieces; emphasis on opinion. We haven’t truly had an inflationary period since bitcoin became popular in the past decade, so there is no way of knowing if its performance has any correlation to U.S. inflation.

Above all else, before jumping to action on your portfolio, remember that inflation is quite hard to forecast. There are an infinite amount of moving parts and multiple ways to measure them. Professional forecasters don’t even agree on what it will look like in the next 12 months, let alone the next ten years or the remainder of your investment time horizon. One of the best ways to hedge against inflation is to talk to your financial advisor and understand how rising inflation might affect your financial plan. That is why we’re here.

Want to know what The Center thinks about inflation? Check out these resources: Inflation and Stock Returns and How Do I Prepare my Portfolio for Inflation.

Nicholas Boguth, CFA® is a Portfolio Administrator at Center for Financial Planning, Inc.® He performs investment research and assists with the management of client portfolios.

Opinions expressed are not necessarily those of Raymond James. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Past performance is not a guarantee of future results. Investing involves risk and investors may incur a profit or a loss. Treasury Inflation Protection Securities, or TIPS, adjust the invested principal base by the CPI-U at a semiannual rate. Rate of inflation is based on the CPI-U, which has a three-month lag. Bond prices and yields are subject to change based upon market conditions and availability. If bonds are sold prior to maturity, you may receive more or less than your initial investment. There is an inverse relationship between interest rate movements and fixed income prices. Generally, when interest rates rise, fixed income prices fall and when interest rates fall, fixed income prices rise. Investing in commodities is generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising. Gold is subject to the special risks associated with investing in precious metals, including but not limited to: price may be subject to wide fluctuation; the market is relatively limited; the sources are concentrated in countries that have the potential for instability; and the market is unregulated. Bitcoin issuers are not registered with the SEC, and the bitcoin marketplace is currently unregulated. Bitcoin and other cryptocurrencies are a very speculative investment and involves a high degree of risk.

Inflation and Stock Returns

Contributed by: Nicholas Boguth

There is a lot of talk about inflation in the news lately, and whether or not the recent spike is “transitory” or if the recent rise in price levels will persist into the coming months, years, or even longer. The problem with forecasting inflation is that it cannot be accurately forecasted. It is a complex topic with ever-changing variables beyond the Fed and money supply including (but not limited to) consumer spending, saving rates, supply chains, government policy, demographics, technological advancements, and much more.

For some high-level context, I wanted to look at the relationship between inflation and stock returns over the past 30 years.

Below, you’ll see a scatter-plot of 1-year changes in CPI and the S&P500. What stands out to me is that an overwhelming majority of those dots are in the top right corner of the graph – positive inflation and positive stock returns. A lot of news headlines we see will put the word “fear” directly next to the word “inflation” because, well…that is what headline writers are paid to do. The reality is that if you look at the long term history of stock performance, you will see that it is positive a vast majority of the time regardless of what happened with inflation.

Source: Morningstar Direct. S&P 500 TR. Monthly return data.

 Investors need to prepare one way or another, and a great way to do that is to talk to your financial advisor and make sure that you are setting yourself up for success no matter what happens with inflation. Helping to maximize your probability of success is something we help all of our clients with, and it may look different for each investor depending on time horizon, risk tolerance, and investing/spending goals. Give us a call or shoot us an email if you have any questions on how to help maximize yours.

Nicholas Boguth is a Portfolio Administrator at Center for Financial Planning, Inc.® He performs investment research and assists with the management of client portfolios.

The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Indices are not available for direct investment.  Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of Nick Boguth and not necessarily those of Raymond James.

How The Historically High Cost Of Retirement Income Affects Your Financial Plan

Contributed by: Nick Defenthaler, CFP®, RICP®

Now more than ever, we find ourselves reminiscing. And if you’re like me, it’s usually about the simple things in life that were so easy to take for granted. Like going out to eat with a large group of friends, having a surprise birthday party for a loved one, or attending a sporting event or concert with a packed arena filled with 30,000 fans having a great time. COVID has caused this reminiscing to occur and it has also played a role in reminiscing of a world where investors used to receive a reasonable yield on portfolios for a relatively low level of risk.

Interest rates have been on a steady decline for several decades now, so COVID certainly isn’t the only culprit to blame here. That said, reductions in interest rates by the Federal Reserve when the pandemic occurred in spring 2020, certainly did not help. As an advisor who typically works with clients who are within 5 years of retirement or currently retired, it’s common to hear comments like, “When we’re drawing funds from our accounts, we can just live off of the interest which should be at least 4% - 5%!”. Given historical dividend and bond yield averages and the fact that if we go back to the late 90s, an investor could purchase a 10 year US treasury bond yielding roughly 7% (essentially risk-free being that the debt was backed by the US government), I can absolutely see why those who lived through this time frame and likely saw their parents living off this level of interest would make these sort of comments. The sad reality is this – the good old days of living off portfolio interest and yield are pretty much dead right now (unless of course, you have a very low portfolio withdrawal rate) and it will likely remain this way for an extended period.

One way to look at this is that the average, historical “cost” to generate $1,000 of annual income from a 50% stock, 50% bond balanced portfolio has been approximately $25,000 (translates into an average yield of 4%). Today, an investor utilizing the same balanced portfolio must invest $80,000 to achieve the $1,000 annual income goal. This is a 320% increase in the “cost” of creating portfolio income!  

It’s worth noting that this is not an issue unique to the United States. The rising cost of portfolio income is a global conundrum as many countries are currently navigating negative interest rate environments (ex. Switzerland, Denmark and Japan). Click here to learn more about what this actually means and how negative interest rates affect investors. Below is a chart showing the history of the 10-year US government bond and US large cap equities from 1870 to 2020.

Source: Robert Shiller http://www.econ.yale.edu/~shiller/

The chart is a powerful visual and highlights how yields on financial assets have taken a nosedive, especially since the 1980s. The average bond yield over 150 years has been 4.5% and the average dividend yield has been 4.1%. As of December 2020, bond yields were at 0.9% and dividend yields stood at 1.6% - quite the difference from the historical average!

So why this dramatic reduction in yields? It’s a phenomenon likely caused by several factors that we could spend several hours talking about. Some experts suggest that companies have increasingly used stock repurchases to return money to shareholders which coupled with high equity valuations have decreased dividend yields globally. Bond yields have plummeted, in part from a flight to safety following the onset of the pandemic as well as the Federal Reserve’s asset purchasing program and reduction of rates that has been a decade-long trend.

The good news is that a low-interest rate environment has been favorable for stocks as many investors (especially large institutional endowments and hedge funds) are realizing that bonds yields and returns will not satisfy the return requirements for their clients which has led to more capital flowing into the equity markets, therefore, creating a tailwind for equities.

Investors must be cautious when “stretching for yield”, especially retirees in distribution mode. Lower quality, high yield bonds offer the yields they do for a reason – they carry significantly more risk than government and high quality corporate and mortgage-backed bonds. In fact, many “junk bonds” that offer much higher yields, typically have a very similar correlation to stocks which means that these bonds will not offer anywhere near the downside protection that high quality bonds will during bear markets and times of volatility. In 2020, it was not uncommon to see many well-respected high yield bond mutual funds down close to 25% amid the brief bear market we experienced. That said, many of these positions ended the year in positive territory but the ride along the way was a very bumpy one, especially for a bond holding!

The reality is simple – investors who wish to generate historical average yields in their portfolio must take on significantly more risk to do so. It’s also important to note that higher yields do not necessarily translate into higher returns. US large cap value stocks are a perfect example of this. Value stocks, which historically have outperformed growth stocks dating back to the 1920s, have underperformed growth stocks in a meaningful way over the last 5 years. This underperformance is actually part of a longer trend that has extended nearly 20 years. Value companies (think Warren Buffet style of investing) will pay dividends, but if stock price appreciation is muted, the total return for the stock will suffer. Some would argue that the underperformance has been partially caused by investors seeking yield thus causing many dividend-paying value companies to become overbought. In many cases, the risk to reward of “stretching for yield” just isn’t there right now for investors, especially for those in the distribution phase. It simply would not be prudent to meaningfully increase the risk of a client’s allocation for a slight increase in income generated from the portfolio.

As we’ve had to do so much over the past year with COVID, it’s important for investors, especially retirees, to shift their expectations and mindset when it comes to portfolio income. Viewing one’s principal as untouchable and believing yield and income will be sufficient in most cases to support spending in retirement is a mistake, in my opinion. Maximizing total return (price appreciation and income) with an appropriate level of risk will be even more critical in our new normal of low rates that, unfortunately, has no sign of leaving anytime soon.

Nick Defenthaler, CFP®, RICP®, is a Partner and CERTIFIED FINANCIAL PLANNER™ professional at Center for Financial Planning, Inc.® Nick specializes in tax-efficient retirement income and distribution planning for clients and serves as a trusted source for local and national media publications, including WXYZ, PBS, CNBC, MSN Money, Financial Planning Magazine and OnWallStreet.com.

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Views expressed are not necessarily those of Raymond James and are subject to change without notice. Information provided is general in nature, and is not a complete statement of all information necessary for making an investment decision, and is not a recommendation or a solicitation to buy or sell any security. There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices generally rise. Past performance is not indicative of future results. There is no assurance these trends will continue or that forecasts mentioned will occur. Investing always involves risk and you may incur a profit or loss. No investment strategy can guarantee success.

How Do I Prepare my Portfolio for Inflation?

Contributed by: Angela Palacios, CFP®, AIF®

Inflation is common in developed economies and, generally, more healthy than deflation. When consumers expect prices to rise, they go out and purchase goods and services now rather than waiting until later. While it is likely that inflation will continue to trend higher here in the U.S. in the coming months the question is “Can this harm my portfolio’s ability to help me achieve my goals?” Consider the following factors contributing to or detracting from the inflation outlook.

Our investment committee has discussed inflation at length for several years now. Here are some highlights from our discussion.

Factors influencing inflation in the short term and long term:

1. Large amount of monetary and fiscal stimulus

   There has been a record amount of stimulus being pushed into the pockets of American’s by the government. The consumer is healthier than it has ever been and demanding to purchase.

2. Supply chain disruptions

   Whether due to shipping constraints or lack of manpower, companies can’t make enough of many different products to meet current demand. Does this sound familiar? It should because a year ago all we could talk about is not having enough toilet paper and disinfectant wipes. People were paying big prices for even small bottles of hand sanitizer.

   Fast forward one year and the shelves are now overflowing with these items and prices have normalized. Once people have spent the money they accumulated over the past year, demand will likely return to normal.

3. Starting from a very low base

   The point to which we are comparing current inflation is one of the biggest influences on the calculation. Right now, for year-over-year inflation, we are comparing to an economy that had very little to no economic activity occurring. When you compare something to nothing, it looks much larger than it actually is. A year from now we will have a more normal comparison base.

4. Wage inflation

   One of the biggest factors in the lack of inflation over the past decade was a lack of wage inflation. We are now seeing wage inflation because companies can’t hire enough people to meet the current demand for their goods or services. Wages are going up trying to entice people back to work. Once government transfer payments slow or run out, many of these individuals will likely return to the workforce again causing wages to return to more normal levels (although it is possible wages settle at a new base that is higher than they were before).

5. A complete lack of velocity of money

   While banks are flush with cash, they still aren’t lending. Why? Because the banks, due to banking regulation changes over 10 years ago, only want to loan large amounts of money to someone who is creditworthy. The creditworthy consumer is so healthy that they don’t need to borrow money.

6. Technology increasing productivity

   A large portion of the country just increased productivity by reducing commute time over the past year via remote working capabilities. Companies that would never have considered allowing remote work now find themselves reducing office space and making permanent shifts in working style. This is just one example of how growth in technology can increase productivity which, over time, puts downward pressure on prices.

It is important to understand what investments could do well if we are surprised and inflation is around the corner.

First of all, your starting point is very important. Are you starting from low inflation or are your inflation levels already elevated? The answer is we are starting from a long stretch of time with very low inflation rates. So in the chart below you would reference the lower two boxes. Then you need to ask, is inflation rising or falling. Low and rising inflation is the bottom left box. You may be surprised to see the strong average performance from varying asset classes in this scenario. Inflation that is reasonable and expected can be a very positive scenario for many asset classes.

In our Second Quarter investment commentary we will dive a little deeper into the asset classes that perform well and how we think about incorporating that into your portfolios!

Angela Palacios, CFP®, AIF®, is a partner and Director of Investments at Center for Financial Planning, Inc.® She chairs The Center Investment Committee and pens a quarterly Investment Commentary.

Webinar in Review: 2017 Mid-Year Investment Update

Co-Contributed by: Angela Palacios, CFP® and DewRina Lee

On June 15, 2017, our Director of Investments, Angela Palacios, CFP®, and Portfolio Administrator, Jaclyn Jackson, covered some interesting topics on the current state of the economy, markets, and politics. Overall, it has been a quiet year with markets marching upwards steadily, with a bit of volatility creeping into technology stocks over the past week.

Here is a recap of key points from the “Mid-Year Investment Update” webinar:

• The Fed Meeting Last Week

  • The Fed approved its second rate hike of 2017 even with inflation running below the central bank’s target of 2%.

  • Diversification remains important in fixed income portfolios.

• Auto Industry

  • Despite record auto sales last year, the vehicles on car-dealer lots remained near record highs earlier this year.* The first quarter of 2017 saw nearly a three month supply sitting on lots.

  • Some producers have already offered buyout packages or announced shutdowns over the summer.

  • The automotive industry is known for its volatile nature, and even now is experiencing a lot of disruptions—electric vehicles, driverless vehicles, and companies like Uber are changing the auto industry.

• Markets

  • Are there any indications of an approaching recession? The index of leading economic indicators has been steadily growing since 2009 with no trend of flattening that you normally see when headed into a recession.

  • Markets have been said to be expensive.

    • Valuations of the S&P 500 are slightly above average for the past 25 years (17.5 versus 16 on average).

• Fiscal Policy

  • If tax cuts and infrastructure spending were to occur, they could offset the potential drag that rising interest rates may have on growth in the U.S.

  • How can this be achieved? Tax reform requires 60 votes (the majority vote is currently at 52) or through budget reconciliation, which can only be done once per year.

• Active/Passive Discussion

  • Not an all or nothing choice. The Center utilizes a blend of lower-cost index investments and we select active managers to complement the core investments to achieve a specific goal such as adding potential outperformance or reducing risk.

•  Trade settling cycle will shorten from 3 to 2 days in September.

  • Reducing credit and counterparty risk, increased market liquidity, lowering collateral requirements.

If you missed the webinar, take twenty minutes and please check out the replay below. If you have questions about the topics discussed, please give us a call!

Angela Palacios, CFP® is the Director of Investments at Center for Financial Planning, Inc.® Angela specializes in Investment and Macro economic research. She is a frequent contributor The Center blog.

DewRina Lee is an intern at Center for Financial Planning, Inc.®

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Any opinions are those of Angela Palacios, CFP®, and DewRina Lee and not necessarily those of RJFS or Raymond James. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. *Sources: https://www.edmunds.com/car-news/auto-industry/new-vehicle-inventory-swells-in-february.html

Investor Basics: Inflation 101

Contributed by: Nicholas Boguth

The most basic definition of inflation is “the rise in price of goods and services.”

Below you will see the Bureau of Labor Statistics’ (BLS) inflation data for the past 10 years, but what do these numbers mean?

Let’s look at last year for an example – average inflation was 1.3%. That means the price of goods and services in the U.S. increased by about 1% last year. It does not necessarily mean that the t-shirt you bought last year for $10.00 is now going to cost $10.10, but rather 1.3% was the average change of all the goods and services that the BLS measures.

Inflation is largely determined by the supply of money, which is why it is a major long-term goal of The Fed to target a certain inflation rate (that target right now is 2%). Keeping a clear inflation goal can promote price stability, interest rate stability, and aligns with The Fed’s goal to help maximize employment.

Since The Fed has explicitly stated that it will be targeting a 2% long-term inflation rate, you may see why investing can be a very important tool for personal retirement planning. If The Fed nails the 2% target, $1 that sits in your change jar for the next 20 years will likely only buy you the equivalent of what $0.67 will buy you today. Feel free to talk to us about strategies about how to combat the effects of inflation!

Nicholas Boguth is an Investment Research Associate at Center for Financial Planning, Inc.® and an Investment Representative with Raymond James Financial Services.

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The information contained in this blog does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Nick Boguth and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Investing involves risk and you may incur a profit or loss regardless of strategy selected. The Consumer Price Index is a measure of inflation compiled by the US Bureau of Labor Studies. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor's results will vary. Past performance does not guarantee future results.