After inflation peaked in the early 1980s, declining inflation reduced interest rates, enhanced bond returns, lifted asset prices, rewarded leverage, and shaped long-term investment strategies. But the age of disinflation is over. Barring radical improvements in innovation and productivity, structural changes promise elevated inflation pressures and periods of higher inflation.
A 2018 study encompassing 22 advanced economies from 1870 to 2016 found that higher inflation is associated with higher proportions of old and young in a population, while lower inflation is associated with larger working-age cohorts. Thus, the rapid aging of the developed world’s population as baby boomers continue to retire foretells growing inflation in coming years. Declining labour participation rates, more worker shortages, higher wage pressures, longer life spans and escalating medical and care costs for the elderly are a potent combination for higher inflation.
Other societal costs are mounting. The green energy transition will take decades and cost tens of trillions of dollars. More extreme natural disasters will escalate insurance premiums, public assistance payments, and infrastructure costs. Lower-income nations will need the assistance of the developed world to fund the costs associated with climate change. At the same time, higher defence spending in a less safe world must be financed. Higher taxes will translate into higher prices as both businesses and workers look to recover increased tax burdens.
Globalization over the past three decades has raised productivity and reduced costs. The shift to prioritizing supply-chain reliability because of the Covid-19 lockdown and the weaponization of trade due to rising polarization promises to reverse these trends. Reduced productivity growth, increased costs and higher wages paid by businesses will all translate into higher prices for consumers.
Elevated inflation will increase the challenge of planning and implementing portfolios that are capable of funding the real spending needs of clients throughout their lifetimes. Here are six portfolio construction parameters to better manage this challenge:
1. Shorten duration of fixed-income holdings. Long-duration bond portfolios were the big winner in the disinflationary decades as interest rates, trending down with falling inflation, lifted bond values, particularly those with longer maturities. In coming years, elevated inflation would increase the likelihood of interest rates increases. Hence, longer-duration bonds are at greater risk for capital losses. In the 1960s, an era when rates progressively moved upward as inflation gradually increased, intermediate-term U.S. government bonds earned a 3.5% annual return, well ahead of the 1.5% of long-term government bonds.
2. Consider an allocation to Canadian preferred shares. As the preferred share market is dominated by rate-resets where the dividend typically resets every five years based on the five-year Government of Canada bond yield plus some defined premium, to the extent inflation lifts interest rates, Canadian preferred-share investors will benefit. Canadian preferred shares offer yields today in the 6% range, well above current inflation levels. Also, when compared to interest income, preferred-share dividends represent a more tax-efficient source of income for a taxable investor.
3. Maintain a healthy exposure to the broad Canadian stock market. A recent study covering 2002–2023 found that natural resource stocks act as a strong inflation hedge, and the Canadian market has much larger material and energy sectors relative to the global stock market (32% versus 9.7%). In the inflationary 1970s, the Canadian market’s 10.4% annual return handily outperformed the U.S. market’s 6.7% return for the same reason.
4. Allocate to real assets. Real estate has traditionally acted as an inflation hedge, as rents and values have historically grown at rates that match or even exceed inflation. A recent study of U.S. sector performance from 1973 through 2022 found that equity REITs were among the top-performing sectors in periods of high and rising inflation. Although utilities underperform during the initial surges of inflation and higher interest rates, this sector has hedging capabilities over longer time frames as the higher costs of capital associated with inflation are reflected in the prices that regulators allow the companies to charge. More broadly, many infrastructure stocks act as inflation hedges because their long-term contracts and regulated frameworks index rates to inflation.
5. Establish an exposure to gold. Gold is a proven long-term hedge against inflation, although its hedging performance in the medium term can be very uneven. From January 2000 to September 2023, gold increased in price at an annual rate of 7%, while the annual inflation rate in Canada was 2.2% per annum. Gold can also act as a safe-haven asset during extremely negative shocks, a critical role in a world of rising geopolitical conflict.
6. Consider trend-following strategies. A comprehensive study of passive and active strategy performance during eight inflationary periods from 1926 through April 2021 in the U.S. found that trend-following strategies that capitalize on commodity, bond, equity and forex trends provided the strongest inflation-hedging capabilities. In respect of stock strategies, momentum outperformed the other equity factors in these periods.
There is a pronounced risk that a lengthy period of elevated inflation is coming. Advisors must consider how they will adjust their portfolios to better meet this challenge.
Michael Nairne, RFP, CFP, CFA, is president and CIO of Tacita Capital Inc., a private family office, and manager for TCI Premia Portfolio Solutions.