By Kim Clark
From Kiplinger’s Personal Finance
Inflation has caused plenty of angst at the grocery stores, but it can wreak havoc with your portfolio too.
“Inflation impacts your portfolio in acute and obvious ways and in more sneaky and nefarious ways,” says Wylie Tollette, chief investment officer of Franklin Templeton Investment Solutions.
Inflation erodes the value of your investments by reducing their purchasing power, for starters. And when inflation is on the rise, central bankers tend to respond with higher interest rates to cool the economy and put a lid on prices.
As bad as inflation can be, stagflation (when inflation is rising but the economy is in a rut) can be worse—as can deflation (when wide-spread, persistently falling prices threaten to destabilize the economy overall).
Economists say there are basically five kinds of “flation.” Here’s how to adjust your portfolio for each one.
Inflation
A little bit of inflation is generally considered beneficial for the economy. But when prices start rising by more than about 2 percent a year, policymakers, bankers, and businesspeople worry. The investments that have historically beaten high inflation include energy stocks, residential real estate held directly and Treasury inflation-protected securities (TIPS) that adjust their principal in line with the consumer price index. Commodity funds also tend to beat inflation. Fixed-rate bonds typically underperform during high-inflation.Disinflation
When the rate at which prices are rising slows, you get disinflation. The good news is that a moderation of inflation is typically a boon for investors because it bodes well for corporate profitability and thus stock prices. During these periods, investors are often rewarded for taking more risks, such as buying stock in growth-oriented companies. Declining inflation also means that bonds bought during the more inflationary period now promise higher “real,” or inflation-adjusted, returns. Commodities, however, have done poorly in previous periods of disinflation.No-Flation
Periods of price stability (typically defined as times when consumer prices overall rise by no more than 2 percent a year) are sometimes referred to as “no-flation.” They tend to be a “golden era for financial assets,” says Gary Schlossberg, global strategist for the Wells Fargo Investment Institute. Price and economic stability create a good climate for just about all investments but especially for riskier investments, such as growth-oriented and small-company stocks, Schlossberg says.Deflation
A generalized, economy-wide drop in prices, or deflation, is rare. That’s good, because deflation can lead to a vicious cycle: a weakening of the economy, lower wages, layoffs, and decreased spending, which in turn ushers in still-lower prices and a further softening of the economy. In the last two periods of deflation, stock prices initially plunged much more than consumer prices and took years to recover. Volatile commodities also tend to suffer. Bonds that pay a fixed, positive rate of interest offer positive real returns, barring a default.Stagflation
Inflation that coincides with stagnation in the job market and the economy, known as stagflation, is truly challenging for investors. Because economic weakness often prevents companies from raising prices enough to recover their costs, profits shrink, and stock returns fail to keep up with inflation. The economy escaped a stagflation scare during the pandemic. If you want to hedge against this type of painful economic malaise, Tollette says your best bet is TIPS, which, if you hold to maturity, are guaranteed to return your investment and move up with inflation.
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