Andelsblatt: What 4 strategies do investors use to protect their portfolio from the risk of stagnant inflation?

Investors today are worried about a scenario that many know only from history books: stagnant inflation. It is a combination of high inflation and economic stagnation.

If stagnant inflation occurs, according to Handelsblatt, it could upset long-term relationships in the capital market. US investment bank Goldman Sachs, for example, sees poorer prospects for bonds in this case. Experts are currently examining how investors can protect themselves from the consequences of such a scenario.

One of the most prominent warnings is former US Treasury Secretary Larry Summers, who had already predicted the current rise in inflation. He recently wrote that the Fed’s monetary policy, which it considers too loose, would most likely lead to stagnant inflation. Other experts also see this risk.

In any case, inflation was already much higher than many economists and central bankers had expected before Russia’s aggressive war against Ukraine. It is now further fueled by the invasion and its aftermath. With Russia, one of the world’s largest exporters of commodities is now largely absent, pushing prices up further. In addition, new padlocks in China threaten to exacerbate supply chain problems.

Laurent Joué, portfolio manager at Lombard Odier Investment Managers (LOIM), says: “The investment world needs to recognize that we are experiencing a stagnant inflation shock.” In his view, although stagnant inflation is not the prevailing scenario, its probability has increased, he says. Experts see four strategies that investors can use to hedge against stagnant inflation – an overview.

1. Prefer tangible assets

If the risks of inflation increase, tangible assets tend to become more attractive, maintaining their value even if prices rise more sharply. A team led by Goldman analyst Christian Müller-Glissmann sees opportunities in such an environment specifically for investing in commodities, real estate and infrastructure, according to a recent study. In the years leading up to the pandemic, these assets outperformed a portfolio of 60% stocks and 40% bonds, which has long been considered a model.

From the experts’ point of view, real assets offer two advantages in times of high and rising inflation: they have yielded comparatively higher returns in such an environment in the past and are less correlated with other forms of investment.

This is the case, for example, with goods. The price of oil is often a good economic indicator. It increases when the outlook for the economy improves and stock markets also increase. At the moment, however, the opposite is true: The price of oil rises when stricter sanctions are imposed on Russia, which restrict the supply of energy. These slow down economic growth and cause stock market losses.

As a result, the price of oil tends to move in the opposite direction from the stock market, which is also true for other commodities. This feature makes investing in commodities attractive as a hedge fund. Goldman Sachs also points out that this has happened more frequently historically and that oil price rallies have often been accompanied by periods of stagnant inflation. In some cases, wars also played a role, such as the Yom Kippur War in 1973, when many Arab states attacked Israel and the producing countries subsequently reduced oil production.

Real estate and infrastructure also offer an alternative. During the stagnant inflation of the 1970s, for example, the US real estate index FTSE Nareit outperformed the broader S&P 500 index, which includes 500 large US companies.

Real estate, for example, offers protection against inflation because it benefits from price increases, and leases often contain contract clauses to pass on inflation. The infrastructure sector has the advantage in times of sharp price increases that companies there usually have a relatively large margin to set prices. This also makes it easier for them to pass on the higher costs to their customers.

2. International differentiation

A classic tip for investors is differentiation. This applies not only to various sectors, but also in regional level. In recent years, however, the greater international diversification of investment has had relatively little effect. Markets have grown relatively strongly and globally, which is evident, for example, in the high regional correlation of stock exchanges. In addition, US stocks gained sharply, with the result that their share in global benchmarks is very high. In the MSCI World stock index, for example, it is almost 70%.

However, Goldman Sachs assumes that this will change in an environment of stagnant inflation and that international diversification will then pay off. Analysts around Müller-Glissmann point out that markets have already grown by a wide margin from region to region since the beginning of the pandemic and that the correlation has diminished. Among other things, because economic cycles have become less synchronized due to the lock-in and larger differences in monetary and fiscal policy.

According to experts, the risk profile can be improved with a higher share of shares outside the US. This is supported by the fact that markets are sensitive to interest rate hikes in different regions. In the US, the share of growth stocks in the indices has increased significantly in recent years. These are considered to be particularly sensitive to interest rate hikes, because their value lies mainly in the prospect of future earnings. However, their numerical value decreases when interest rates rise.

Conversely, this is not such a big problem for companies that are already making high profits at the moment. These are more important in areas like Europe. John Vail, chief strategic analyst at Japanese asset management firm Nikko AM, also believes that US valuations are “still high” at a price-to-earnings ratio of around 20 and expects to be under pressure from rising bond yields.

3. Use of cash as a hedge

Normally, bonds are the classic hedge instrument in many portfolios. The logic behind this is that stocks are moving in the opposite direction. If, for example, a recession is threatened, this usually causes stock prices to fall. Bonds, on the other hand, tend to rise because central banks react by lowering interest rates, which leads to higher bond prices.

In the case of stagnant inflation, however, investors face not only the risk of recession, but also the risk of inflation shock. Assets that perform well during a recession, such as bonds, do not necessarily do so when inflation rises sharply. If prices rise, central banks raise interest rates, as is the case today in the US, for example. This in turn leads to higher yields and lower bond prices.

Compared to bonds, cash can therefore be the best alternative in such an environment to reduce portfolio risk. Although it is also undervalued by inflation, it is at least protected from price losses. Lombard Odier’s portfolio manager Joué sees it as an option for investors worried about both the risk of recession and the shock of inflation. “Cash has historically been an excellent means of offsetting stagnant inflation.”

4. Examine dividend shares, convertible shares and value shares

For a long time, portfolios with 60% equity and 40% bonds offered an almost perfect blend. In times of falling inflation and rising corporate profits, they produced good returns with relatively low volatility. In the event of stagnant inflation, however, the correlations could change.

Goldman Sachs experts see the risk that 60/40 portfolios will produce low real returns for longer. In their view, alternatives for investors also offer some mixed forms of bonds and shares. One of them is dividend shares, which, like bonds, provide investors with stable cash inflows. For example, US stocks with the highest dividend yield outperformed the S&P 500 during the stagnant inflation of the 1970s, just as they did after the dotcom bubble burst in the early 2000s.

Another hybrid form is the convertible bonds, ie the bonds with the right to purchase shares. Like bonds, they offer interest and have a fixed maturity at the end of which they are repaid. Their interest rates are lower than those of conventional bonds. On the other hand, investors can exchange them for shares over the duration. Due to the market right associated with them, their performance also depends on the stock market.

Low-value stocks can also be interesting for differentiation. This applies to areas such as telecommunications, banks or utilities. Goldman Sachs experts point out that value stocks are less correlated with technology stocks in the last two years. Compared to the latter, they have the advantage that they are less sensitive to changes in interest rates. However, they tend to be more cyclical and therefore more vulnerable to a growth downturn.