Markets & Strategies

What Does Inflation Mean for You?

Held in check for so long, the inflation rate is expected to rise.

by Suzanne Bopp - April 24, 2017

After years of low inflation following the recession, Wells Fargo Investment Institute (WFII) is anticipating higher inflation in 2017 and beyond, with the inflation rate expected to begin returning to more normal levels. While investors unprepared for the increase could get caught flat-footed, those in the know can take steps to help make sure their portfolios are ready.

The outlook

This increase is not expected to be a dramatic one. “In the near term, we are likely to see inflation slowly trend higher, but I wouldn’t expect it to get overheated,” says Brian Rehling, Co-Head of Global Fixed Income at WFII. By year’s end, WFII anticipates inflation will reach 2.2%. (In 2016, rates mostly stayed between 1 and 2%.)

While inflation may not always be thought of in the most positive light, there’s good news behind its rise. “You tend to see inflation move higher when growth is strong and people have jobs and are making more money, because, of course, they are more comfortable spending money,” Rehling explains.

Energy prices and food prices play major roles in inflation, and last year commodities prices stayed very low, says Tracie McMillion, Head of Global Asset Allocation Strategy at WFII. “In particular, oil prices were decreasing pretty significantly. Commodities prices have begun moving a little higher, and that’s going to impact what we call the ‘top line’ of our inflation measures, which includes both energy and food.”

By year’s end, Wells Fargo Investment Institute anticipates inflation will reach 2.2%.

In the longer term, inflation is currently not expected to rise much higher than what we see in 2017, Rehling adds, thanks to factors such as an aging demographic and high government debt levels. “Some people worry about high debt levels causing interest rates to rise, but they can actually be disinflationary because money has to be diverted from productive economic uses into servicing debt loads,” he says.

That diversion from production plays into another factor that may keep inflation in check — relatively slow growth. “Higher growth leads to inflation in its classical sense,” Rehling says. “We expect growth to continue at a modest pace.” The Federal Reserve projects 2% inflation in 2018 and in 2019.

Impact on stocks and bonds

What might a rising inflation rate mean for investors? “What I think is most important for investors to know is that as inflation ticks higher, interest rates are probably going to move with it,” McMillion says. “We believe the Federal Reserve likely will continue to increase interest rates as inflation approaches their target rate [2%]. We also believe bond market interest rates should also move higher over time to compensate for higher inflation levels.”

As bond yields move higher due to increasing interest rates, existing bond prices may move lower. “That’s something that many investors don’t always fully grasp: It’s an inverse relationship,” McMillion says. “Existing bond prices go down because new bonds are being issued at higher yield rates.”

Investors will still want to hold bonds, she says, because they provide a stabilizing component for a portfolio. But she suggests that most investors hold the majority of their bond investments in short-term or intermediate-term bonds — those within about seven years of maturity — which are less impacted by higher inflation rates.

Stocks, meanwhile, may benefit from the kind of moderate inflation that is expected. “Companies can often expand their profit margins a little bit when inflation is moving higher,” McMillion says, which typically has had a positive effect on the price of shares of that company’s stock.

Investors will still want to hold bonds because they provide a stabilizing component for a portfolio.

Hedges against inflation

If investors have concerns about inflation increasing more than is being predicted, Rehling suggests they consider a bond ladder, a fixed-income portfolio in which each security’s maturity date is different; while not created specifically for inflation, they work well in many environments, including today’s.

“You would probably want to be more defensive in your investments,” he says. “Probably some of your performers would be real assets — something like gold. We currently like real assets in the real estate space. You could also add into your well-diversified portfolio products like TIPS: Treasury Inflation Protected Securities.” TIPS are a fixed-income product in which prices generally rise as inflation projections increase — this is referred to as the adjusted principal. TIPS pay interest twice a year at fixed rates on the adjusted principal, and then at maturity, investors receive either their principal or the adjusted principal back, whichever is higher.

Still, because Rehling is not overly concerned about the outlook for inflation, his bottom line recommendation doesn’t depart from his usual investing advice. “I think the most important thing for investors today, given the wide range of potential outcomes, is to have a solid asset allocation and to remain diversified.”

Suzanne Bopp has written for Salon.com and Utne Reader.

Image created from iStock

Additional Resources

Lifescapes offers more on this topic:

Learn more from Brian Rehling about the current state of bonds.

Tracie McMillion and Sameer Samana of WFII discuss investment strategies for volatile markets.