What Does Inflation Mean for Investors?

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

by Suzanne Bopp - February 05, 2018

After years of low inflation following the recession, Wells Fargo Investment Institute (WFII) is anticipating higher inflation in 2018 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 who are prepared can take steps to 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 2.4%. (In 2017, 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 in 2016, 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 moved 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.”

Wells Fargo Investment Institute anticipates that inflation will reach 2.4% by year end.

In the longer term, inflation is currently not expected to rise much higher than what we see in 2018, 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 generally leads to inflation in its classical sense,” Rehling says. “We expect growth to continue at a modest pace.” The Federal Reserve projects at least 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.”

We believe investors should still 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.

Hedges against inflation: real assets and TIPS

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.

“Investors may want to be more defensive in their investments,” Rehling says. “Perhaps by investing in real assets — such as gold. We currently like real assets in the real estate space. Investors may want to consider adding to a well-diversified portfolio with products such as 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 USA Today and National Geographic Traveler.

Image created from iStock

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All investing involves risks including the possible loss of principal. Equity securities are subject to market risk which means their value may fluctuate in response to general economic and market conditions and the perception of individual issuers. Investments in equity securities are generally more volatile than other types of securities.

Bonds are subject to market, interest rate, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. TIPs are subject to interest rate risk especially when real interest rates rise. Bond laddering does not assure a profit or protect against loss in a declining market. Yields and market values will fluctuate, and if sold prior to maturity, bonds may be worth more or less than the original price.

Exposure to the commodities markets may subject an investment to greater price volatility than an investment in traditional equity or debt securities. Investing in physical commodities, such as gold, exposes a portfolio to other risk considerations such as potentially severe price fluctuations over short periods of time and storage costs that exceed the custodial and/or brokerage costs associated with a portfolio’s other holdings.

There are special risks associated with an investment in real estate, including the possible illiquidity of the underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions.

General Disclosure:

Wells Fargo Investment Institute, Inc. (WFII) is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

There is no assurance that any of the target prices or other forward-looking statements mentioned will be attained. Any market prices are only indications of market values and are subject to change.

Opinions represent WFII’s’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. WFII does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.