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Protect Your Portfolio From Rising Prices

We have all noticed increases recently in prices at the gas pump and in the grocery store. Bidding wars are happening across the country when homes go on the market, and in some cases used cars cost more than a brand new one of the same make and model. What we are all feeling is the effect of inflation.

Consumer prices rose 7.9% in February, which means that inflation is at a level we have not seen in more than 40 years. Initially, many thought that inflation would be transitory, but it’s clear that Jerome Powell’s thoughts have changed, and the Federal Reserve has indicated that they plan to start raising interest rates in March to try to cool the steady increases in prices.

This will be an interesting balancing act, attempting to get inflation under control while at the same time attempting to avoid throwing the economy, which is still weakened by the pandemic, into a recession.

Where does this leave us as investors? At its basic level inflation represents the rise in the price of goods and services. It reduces the purchasing power of our dollar. In this environment, consumers may lose purchasing power unless their income rises, and Fed action to get inflation under control can damage growth and employment.

The war in Ukraine is also complicating the inflation picture. Russia and Ukraine produce about 30% of the world’s grain. Shortages in grain will increase the prices of many consumer goods, including bread, meat and even alcohol. Additionally, sanctions on Russian oil have increased prices at the pump. Oil price gains reverberate through the economy, affecting business profitability and the cost to ship items to consumers as well as the cost of travel.

Early in the cycle before a rate hike, the market tends to perform well. It also performs well relatively early in the rate hike cycle.

But we also know that in periods of high inflation, P/E ratios (the price of a stock relative to its earnings) tend to compress. The higher the level of inflation, the more this happens, and stock prices fall in the short term. A rate of inflation at around 4% seems to be where we begin to see more significant multiple compression. Increasing earnings for businesses can help put a damper on this phenomenon.

Knowing this, should investors be running for the door to get out of the market? Quite the contrary. Over time stocks are the best way to hedge against inflation. If we have set the asset allocation of a client’s portfolio with an appropriate mix of stocks, bonds and cash, clients should be able to weather the volatility. The purchasing power of cash is eroded during times of high inflation, so we are recommending that investors limit their cash holdings to whatever is needed in the event of an emergency or to provide funds for known upcoming expenses.

For our bond allocations, we also advise clients to keep the duration of their portfolios very short. Interest rates rise in periods of high inflation. The longer the term of the bond or the lower the quality, the more the bond price will fall when rates increase. Staying short and remaining in high-quality bonds is a defensive strategy that also allows us to take advantage of higher rates as bonds mature.

The best way to hedge against inflation over the long term has been to own high-quality businesses. Looking back over time at various asset classes, stocks have outperformed. When inflation kicks up, we frequently get asked whether we should add gold as an investment option in our client accounts.

As the chart above displays, stocks have provided a superior return over time when compared to gold. Gold tends to do well during periods of market panic, but as a long-term holding, we would much prefer to own a high-quality company with a competitive business advantage that should make it a leader in its industry. We take a long-term business owner approach to owning stocks. Our focus on the business, the management, and the price we pay for our equity holdings has allowed Baird Trust clients to build wealth over full market cycles.

We appreciate the trust you have placed in your team at Baird Trust and encourage you to reach out if you have any questions or concerns.