Do’s and don’ts for the new investment environment
By now, you’ve noticed that the prices of everyday essentials from groceries to gas to lumber have edged up, some quite significantly. No, you’re not dreaming, and it’s not a mistake. Consumer price indexes have risen sharply in recent months. For instance, Canada’s main all-items inflation index jumped to an annual rate of 3.4% in April, from 2.2% in March. It’s even worse in the U.S., where the all-items inflation index spiked to an annual rate of 5.0% in May. After a long period of relative calms, it seems prices are surging.
Central bankers and analysts in both Canada and the U.S. have been quick to explain that these sudden price increases can be largely attributed to a combination of strong economic growth following 18 months of pandemic-forced lockdowns and a low starting base for calculating the 12-month change in their rate of inflation. The banks point to their own previous forecasts of just such a surge in inflation rates, and their belief that the surge will be transitory. Any tapering of monetary accommodation, they’ve said, would hinge very much on whether economic growth continues at its red-hot pace, whether job creation continues to expand, and whether wage inflation starts to take hold as businesses scramble to meet demand and compete for employees in an ever-tightening labour market.
One key indicator to watch closely is the yield on benchmark long-term government bonds. Yields on 10-year Government of Canada bonds and 10-year U.S. Treasurys have risen notably over the past few months. Yields on Canadas have risen to 1.45% in mid-June, from 0.68% in January. Similarly U.S. Treasurys have climbed to 1.5% from 0.917% in early January. Persistent inflation always moves bond yields higher in lockstep, as investors seek to offset erosion of purchasing power. Yields have been rising steadily since last August, and because bond yield and price are inversely correlated, bond prices have declined, putting something of a dent in fixed-income portfolios.
When central banks begin tightening monetary policy in earnest (probably later this year), the stock market is likely to throw a “taper tantrum,” declining or perhaps even correcting briefly, as investors digest a new era of tapering quantitative easing (i.e., the phase-out of bond buying by the central banks) as a prelude to increasing policy rates from their current near-zero level. Higher rates mean increasing borrowing costs, and reduced earnings, the expectation of which has investors re-pricing shares downwards – at least temporarily.
What, then, can investors do to offset the effects of rising inflation on their portfolios?
Right off the bat, forget about trying to “time” stock market shifts. This is virtually impossible to do with any degree of accuracy if you think the market is about to sell off in reaction to even a hint of hawkishness by the central banks. In order to do this, you have to try to sell at a market top and then get back in at the market bottom. Trouble is, no one knows when these occur, except in hindsight. And the danger is that you’ll miss both exit and re-entry points, losing a lot of your capital in the process.
Instead, focus on a slight rebalancing your equity portfolio, which should already be well diversified, with a tilt towards companies that stand to benefit from economic growth and even inflation, and away from purely “defensive” types of holdings. So instead of overweighting to areas like consumer staples, utilities, and technology, which are typically prescribed for low-rate environments, you might want to consider more cyclically-oriented sectors, like materials, industrials, and consumer discretionary. For example, the S&P/TSX Capped Industrials Index has already advanced 8.4% year to date to June 14, while the Global Base Metals Index has surged 19.1%. Financial services typically also benefit from a rising-rate inflationary cycle, as banks borrow at the short end of the curve and lend at the long end, where rates rise much faster.
Your wealth manager may also recommend lightening up on your fixed-income holdings, going from, say, a 60/40 bond-equity split to a 40/60 split. Fixed income takes a beating in a rising rate environment as bond prices decline when rates increase. You won’t want to abandon bonds entirely, as they supply diversification and income, particularly if held to maturity, and help to reduce overall portfolio volatility.
The post-COVID era will remain a challenging one for investors, but more in the sense of trying to position your investments to benefit from surging growth and attendant inflation rather than to be steamrollered by it. Some judicious planning now, and a talk with your financial advisor, would be a good place to start.