As we embark on four years of Donald Trump in the Oval Office, no one knows if Trump’s policies, which center on lower taxes, deregulation and expansionary fiscal policy, are simply political rhetoric or if they are serious proposals that a Republican majority in Congress will craft into legislation.
And that uncertainty has investors around the globe perplexed (see Can the Trump Stock Rally Last?).
Trump’s policies combined with stabilizing commodity prices and low unemployment have the potential to increase economic growth along with inflation, while a tighter Fed policy and stronger U.S. dollar could keep inflation contained. The consensus among economists is that inflation will increase to north of 2% in 2017, which would mark the first time since prior to the Credit Crisis that we’ve experienced consecutive years of inflation above 2%.
Below we examine how financial professionals can use different asset classes to help position client portfolios to guard against inflation as well as contribute to total returns. We also list some of the top performing strategies from the PSN Global Manager Neighborhood database for each asset class during years of inflation over two percent.
Inflation risk is typically associated with fixed income products since inflation reduces the purchasing power of fixed interest payments the investor receives. Additionally, the Fed typically increases rates during times of rising inflation to cool the economy, which decreases the prices of fixed income products.
Fortunately, fixed income investors have choices to help hedge against inflation risk.
Treasury Inflation-Protected Securities (TIPS)
The most popular option are Treasury Inflation-Protected Securities (TIPS), which help protect against unexpected inflation because their interest payments reflect the stated fixed interest plus the inflation amount as measured by the Consumer Price Index (CPI). Additionally, the bonds’ principal also adjusts as the CPI changes.
Floating Rate Bonds
As we mentioned above, rising interest rates often coincide with inflation, making floating rate bonds a good option to hedge inflation and interest rate risk, as their interest payments adjust to changes in key interest rates. Conversely, medium and longer-term bonds typically underperform due to the rising interest rates and erosion of the fixed interest payments.
High-Yield and Emerging Market Debt
Today’s low-yield environment causes additional concerns as financial advisors must search for higher-yielding investments to meet income requirements. Depending on the investor’s risk tolerance, this additional yield may be found in high-yield and emerging market debt. The commodity-rich emerging market economies fare well during inflationary periods as the prices of commodities tend to increase.
If inflation has you really concerned, convertible bonds provide investors with a product that has bond-like features with the bonus to capitalize on the potential increase in the common shares price.