Key Questions: How Should Investors Position Their Portfolios as the Fed Faces an Inflation Dilemma?

Brian Pietrangelo, Managing Director of Investment Strategy, KeyBank Investment Center

<p>Key Questions: How Should Investors Position Their Portfolios as the Fed Faces an Inflation Dilemma?</p>

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Inflation has remained persistent, lasting longer than some have predicted. The environment has created unwelcome challenges for both individuals and the Federal Reserve (Fed). Investors should revisit their portfolios to consider the uncertainty regarding the Fed’s potential actions.

We have written numerous articles on the topic of inflation and its implications. Because of its persistence, we believe further commentary is warranted.

On Wednesday, August 10, the Bureau of Labor Statistics will release its inflation reading for July, as measured by the Consumer Price Index (CPI). In the June release, CPI rose 9.1% from the prior year, the largest increase since December 1981. Moreover, various components within the June CPI saw large increases – food (+10.4% year-overyear), energy (+41.6%), goods (+7.2%) and services (+5.6%). These increases are all well above historic norms of 2%, undoubtedly straining many hardworking families. The July data will be critical as observers will be poring through the report to discern whether inflation is peaking. 

On a lighter note, I was reminded of inflation while eating out at multiple local restaurants this past month. Not only were prices higher overall, but I was shocked to see the menus reflect the cost of a basket of chicken wings listed as “market price,” as if to connote the marquee entrée at a high-end seafood establishment. Furthermore, although the official CPI data indicate only a 20.4% escalation in chicken prices, the actual prices on the menu reflected an increase of more than 100%.

Is the Fed Playing ‘Chicken’?

The Fed’s dilemma is that it risks pushing the economy into a recession if higher interest rates slow the economy too much, leading to lower economic output and higher unemployment. The decision to raise interest rates earlier in the year was inevitable. The decision to continue raising rates through the end of the year is debatable. 

It seems to me that the Fed is entangled in a classic game of “chicken” (pun not intended), where actual adversaries or game theory competitors attempt not to yield by blinking first. The Fed has legitimate economic purpose (and technically, a congressional mandate) to fight inflation. 

The timing of rate hikes is paramount. If inflation begins to subside on its own while the Fed continues to raise rates into the future, it may be applying pressure when it might not be necessary anymore – leading to negative economic repercussions. To be fair, the Fed’s task is extremely challenging and should be respected. As an indication of this difficulty, during the July press conference, Fed Chair Jerome Powell said it “will adopt a meeting-to-meeting stance” in terms of its evaluation and decision on raising interest rates.

How Should You Respond?

So, what does this mean for investors? It means continued uncertainty.

How should investors be positioning their portfolios to address this uncertainty? 

Even if the Fed is successful in reducing inflation from its current level of 9.1%, it likely still will take time for it to get back to pre-pandemic levels of 2%. Therefore, above-normal inflation may be with us for a while. As such, we believe having dedicated positions to hedge inflation within an overall diversified portfolio makes sense.

Here are Some Strategies to Consider:

Equities: Over longer periods of time, equities have been a reasonably good solution for keeping pace with inflation as prices are passed through to corporate earnings and therefore stock prices. A challenge for equities is that they can fluctuate greatly, as experienced in the first half of 2022. However, investing now (as valuations have fallen) may be beneficial.

Inflation-protected bonds: Two types of inflation-protected bonds are typically used by investors – Series I bonds and the Treasury’s inflation-protected securities (TIPS). Both instruments contain an interest component (yield) plus an inflation-adjustment component tied to CPI. But there are challenges for both.

I bonds are limited to a $10,000 annual investment and are purchased directly from the US Treasury website, which means they cannot be combined in the same account as other investments in your portfolio.

TIPS may protect against inflation risk, but they still carry interest-rate risk, as all bonds do. TIPS are down 5% year-to-date; however, they may provide some buffer to stocks that, as noted above, are inherently more volatile.

Commodities or commodity-based equities: Investments in commodities provide a high correlation to inflation and therefore act as a hedge, but commodities come with significant volatility, even more so than equityrelated volatility. 

Conversely, we prefer investments in commodity-based companies for two reasons:

  • Investing in equities provides cash flow and valuation opportunities rather than just the price of the commodity as a hedge.
  • We believe that there is a super-cycle for certain commodity-related companies, which results from a long-term demand/supply imbalance, rather than the supply-chain, pandemic-related imbalance that occurred over the past two years.

Real estate: Real estate investments are typically accessed either through real estate investment trusts (REITs) or private real estate limited partnerships (LPs). Both have historically performed reasonably well as inflation hedges because rent increases typically occur during inflationary periods. Both are sensitive to rising rates and have seen declines this year. Based on the fact that public REITs are highly correlated to equities, we prefer private core real estate as part of a portfolio for diversification, income and lower-volatility benefits. A challenge with private real estate is accredited investor/ qualified purchaser eligibility and illiquidity features.

Combined solution of real assets: As mentioned above, each inflation-hedging solution has pros and cons. To mitigate risks associated with those solutions, we favor constructing a diversified real assets portion of an investor’s portfolio that combines multiple strategies with the purpose of "inflation hedging." This solution is comprised of multiple assets, including TIPS, gold, infrastructure, natural resources and private real estate. 

Key Takeaways

Inflation may soon start showing signs of cooling, but it will likely remain above the Fed’s target, requiring investors to incorporate a broader set of tools within their portfolios. The strategies referenced above all come with various risks, but all have the potential to play a useful role within a well-diversified portfolio.

For more information, please contact your advisor.


Brian Pietrangelo Biopic

About Brian Pietrangelo

Brian Pietrangelo, MBA, CIMA,® AIF,® is Managing Director of Investment Strategy at Key Private Bank. He has more than 25 years of experience in areas of leadership, investment strategy, investment research/manager due diligence, client relationship management, asset management, and product development. He leads the effort responsible for enhancing the communication and effectiveness of investment strategies, guidance, and solutions tailored to our clients’ unique needs. Brian joined Key Private Bank in 2021 and his prior tenure included serving clients and the business for Charles Schwab, Merrill Lynch, and Willis Towers Watson (Towers Perrin/Watson Wyatt)..

Brian earned his bachelor’s degree in Finance from Miami University (Ohio) and his MBA from the University of Dayton. He also attended the University of Chicago Booth School of Business Executive Education program and holds both Accredited Investment Fiduciary (AIF®) and Certified Investment Management Analyst (CIMA®) designations as well as previously having the FINRA Series 7 license.

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