Investment Strategies to Outpace Inflation
Inflation has been running hot in recent months compared to its multi-year trend, and strategies to protect wealth are paramount in this uncertain environment. The year-over-year and month-over-month change in the core Consumer Price Index recently hit its highest levels since 1991 and 1981, respectively, and the outlook for inflation remains highly uncertain.
Given inflation’s potential to destroy the value of hard-earned wealth, wise investors should position their portfolios to mitigate and take advantage of inflation’s potentially damaging effects. The following are some guiding principles to generate investment returns in an inflationary environment.
Stocks over Bonds
The most damaging effect of inflation is its ability to erode purchasing power. When investing during a period of high inflation, investors should target real returns – the return realized net of inflation. Bonds with fixed payments are vulnerable to increases in inflation as the payment amount remains the same but its purchasing power declines. Increases in inflation over the life of a bond reduce the real return an investor earns on a like-for-like basis.
Returns on stocks, in comparison, are anything but fixed – dividend payments change and share prices fluctuate. However, not all companies are created equal and it is important to choose investments carefully.
During an inflationary environment, companies with strong pricing power and high degrees of operating leverage are well-positioned.
Pricing power is very important in an inflationary environment. Companies with strong brands and differentiated goods or services are better able to pass cost increases through to customers, creating a competitive advantage during periods of inflation. The ability to pass along prices protects margins and earnings and should lead to improved performance.
Operating leverage is another important factor to look for when selecting stocks during periods of inflation. Operating leverage refers to a company’s percentage of fixed costs relative to total costs. Companies with substantial fixed costs can generate strong margin expansion during inflationary cycles as increases in selling prices tend to outpace growth in operating costs.
Hedging is another way to protect against inflation. Hedging strategies can become extremely complex, but two simple ways to protect against inflation include investments in commodities and inflation-protected securities.
Commodities can serve as a useful hedge in an inflationary environment. Exposure to a broad portfolio of commodities should protect wealth during times of high inflation.
Inflation-protected securities are investments indexed to the rate of inflation. A common form is Treasury Inflation-Protected Securities (TIPS). With TIPS, the principal amount is periodically adjusted to account for increases in the consumer price index – negating the impact of inflation on purchasing power.
How Should You Invest to Beat Inflation?
If you are worried about inflation and looking to protect wealth, First Western Trust has experienced investment managers that can help you reach your goals and navigate this fluid environment.