Combating Inflation with Diversification
For years, the primary concern about inflation in the U.S. was that there was not enough. Now, largely thanks to the pandemic, we are suddenly flush with price increases and the Fed has officially turned its focus from improving employment to inflation containment. How should investors be positioned to face this rising concern?
Let’s start this discussion first by saying that high, sustained inflation is not inevitable or perhaps even likely. Absent a pandemic, rapid technological developments have become a deflationary force. Think about the $4000 you could have spent on a 46″ 1080p “flat screen” TV back in 2005 compared to the $300 for a 50″ 4K Ultra HD TV today. Those dynamics are not going away. In addition, beginning this week, The Fed has squarely placed its attention on limiting inflation. The reality is that investors still do not know if this current bout of inflation will be transient and that is okay.
Such is the nature of investing. We are never in a position where we have definitive information about the future. Therefore, the goal should not be to load up on risky assets, like commodities, that tend to outperform during inflationary periods, but rather ensure that you have a portfolio that is ready for the future, in whatever form it takes. We call that a “well-diversified” portfolio. It is easy to be diversified but more challenging to be well-diversified.
To do so requires looking deeper than just “stocks and bonds.” What stocks? Do you have broad factor exposure (like Quality, Value, Momentum, and Size), or are you focused too heavily on mega-cap growth? Do you have international exposure, including emerging markets? Do you have enough small-cap exposure? Equities provide some inflation protection but have you considered Gold and Treasury Inflation-Protected Securities (TIPS)? Have you appropriately avoided risky, illiquid asset classes like alternatives and cryptocurrencies? A well-diversified portfolio correctly addresses all of these questions.
Stocks fell nearly 2% this week. A plethora of economic data was released, but only two things really mattered to investors this week: The Fed and Omicron.
Wild Wednesday
The conclusion of the Fed’s FOMC meeting on Wednesday was bound to make waves and investors were not disappointed. Stocks rallied as the Fed Chairman spoke, sending the S&P 500 up to near all-time highs. So what did the Fed say? They:
- will double the pace of asset purchase tapering from $15B a month to $30B,
- removed “transitory” as an adjective to describe inflation,
- showed a median forecast for three rate hikes in 2022,
- do not see a long delay between tapering and rate hikes.
Inflation has been an overhang on sentiment recently. This week (or at least on Wednesday), investors were comforted that the FOMC is setting its sights on controlling inflation, even if it means getting more hawkish (which is generally a headwind for portfolios).
Variant Velocity
Also impacting sentiment this week were headlines surrounding the Omicron Covid variant.
- The relatively new strain of Covid is spreading fast and appears much more transmissible than Delta.
- However, early indications continue to be that the symptoms are less severe.
- Concerns are rising of a fresh wave of closures and restrictions, which could prolong the economic recovery.
- Time will tell what is required to stave off this latest Covid challenge.
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