Inflation is Here. What Does that Mean for Your Investments?

There’s no question that we are in a period of significant inflation.  It’s evident any time you visit a grocery store, fill up your car with gas, or dine in a restaurant.  Earlier this year the Consumer Price Index, a government measure of inflation, hit a 40-year high, spooking investors and putting equities into a tailspin.   Of late, we find ourselves discussing with clients if and how the resurgence of inflation would impact an investor’s asset allocation and what investments might be more attractive given the surge in inflation.

According to legendary investor Warren Buffett, investors should focus on companies that have the ability to increase prices rather easily, so that inflationary costs are absorbed by the end user, without the company having to bear significant loss of either market share or unit volume.  Examples of this would be consumer staples, such as branded food or personal care companies.  Additionally, Buffett says that investors should avoid companies with high capital expenditure requirements, such as utilities and railroads.

During this inflationary period and in general, we at First Long Island Investors recommend that investors look to high quality dividend paying companies, as they are a good long-term investment and provide some measure of safety.  These companies are typically larger, more mature businesses and have a culture of being shareholder friendly.  Their commitment to paying dividends forces company management to be disciplined with their use of cash which contributes meaningfully to their total return.

Additionally, while history is only a guide, in higher-inflation environments mid-cap and small-cap stocks also tend to do well.  Sectors such as energy, REITS, financials, and materials historically have outperformed during these periods.

Bond markets tend to get hit hard during inflationary periods, as fixed coupon securities will perform poorly during a rising rate environment.  However, there are some types of bonds that provide inflationary protection.  For example, step-ups have increases in interest rates at certain points in time and variable rate bonds provide some inflationary protection.  Treasury Inflation-Protected Securities are another way for fixed-income investors to protect themselves from the effects of inflation.  These securities increase the underlying principal amount by the rate of inflation, so that there is no loss of purchasing power.

A common question asked by investors in times when the markets are rocky is how much cash to hold.  The answer is different for each individual or family based on their specific situation and can be a difficult one to reconcile.  On one hand, investors may want to try to reduce cash holdings during an inflationary period because the value of their cash will erode over time, perhaps significantly so, as each dollar will buy less than it could before.  On the other hand, having the appropriate cash buffer helps investors weather volatile markets and allows an investor to “sleep at night.”

One should remember that even though inflation is high now, it will not remain high forever.  The ideas above can be considered by investors as they evaluate minor portfolio changes and other diversification strategies, but for the long-term investor with a well thought out and time-tested asset allocation generally staying the course and not acting emotionally may be the best approach.