How to inflation-proof your portfolio

For the past five years, investors have been the proverbial frogs in the pot of cool, comfortable water. But 2017 will be the year things start to heat up, courtesy of inflation and higher rates. The trick will be to keep your eye on the thermometer so you don’t get burned, never mind boil alive.

Not only is the U.S. Federal Reserve beginning to ratchet rates higher, inflation in all developed economies is expected to be within the 2 to 3% range. While those projections are still muted that would still put inflation at its highest rate since the financial crisis. Even with modest inflation rate of 2% investors need to consider how that might affect their portfolio. 

Rising inflation represents a real threat to retail investors, particularly since they have been moving into bonds and out of equities since the financial crisis, says Paul Taylor, senior vice president and chief investment officer at BMO Global Asset Management. “Given that reliance on bonds we are vulnerable to a change in the bond market,” he says. “Some investors are unaware they can lose money in bonds.”

Investors may already be feeling the pain. Since the U.S. election, equities have been firm to the upside, while bonds have been crushed. “This is fundamentally different from the past 30 years,” explains Taylor.

Inflation can be a positive for investors

While inflation introduces risks that investors haven’t had to consider for some time, it’s not necessarily a bad thing. “If you have abnormally low growth and very low inflation then a little bit of demand inflation can be helpful because it means companies can raise prices,” says Stephen Lingard, senior vice president and portfolio manager at Franklin Templeton Soultions. This would allow earnings to climb again after having only recently recovered back to where they were in late 2015.

Lingard adds an important caveat. Inflation has to be driven by real growth in the economy, he says, not stagflation, which refers to rising inflation buttressed by slow growth and high unemployment.

High multiples—or higher than normal price-to-earnings ratios—might be another reason why investors might welcome inflation. This is a particular concern in the U.S. The PE ratio for the S&P 500 currently sits at 21 versus the average over the past decade is closer to 17 (see chart below). High multiples mean you’re paying more for equities than you normally would.

Rising inflation could help push earnings higher and help return those multiples to a normal range. Although there are headwinds to consider. Sam Stovall, chief investment strategist at CFRA Research in New York is forecasting the S&P 500 earnings per share to rise nearly 12% in 2017. Although, in a research note Stovall adds that with inflation of 2% EPS growth will need to exceed 15% and 20% in order for the S&P 500 to top the 2,400 and 2,500 levels, respectively, by the end of the year.

How should you reposition your portfolio?

Putting aside the outlook for equities Lingard he warns against complacency. Last year investors were ill-prepared when interest rates started to reverse course, he says. There are really two markets investors need to consider, he adds. Defensive, bond proxies and classic defensive sectors like utilities are looking particularly expensive right now, he says. The cheaper sectors are the ones that have been left behind in recent years, like financial stocks. While Lingard notes some investors are taking profits on these stocks he still feels they have room to go higher.

As a fixed income alternative you might want to consider preferred shares. They were beaten up as rates fell, but they should rebound as interest rates start to rise, explains Taylor.

Few retail investors have the time or resources to properly research and trade preferred shares directly, but ETFs provide easy access to this asset class. The three biggest ETFs in this space are the BMO Laddered Preferred Share Index (ZPR), the Claymore S&P/TSX Canadian Preferred Share ETF (CPD) and the Horizons Active Preferred Share ETF (HPR). Each of these ETFs are heavily weighted in energy and financial stocks, which also stand to do well if inflation picks up. 

But there is still another factor to consider. As interest rates climb, there is the added risk that bond yields could start to look attractive enough that money could stampede out of stocks and into the fixed income market. Some pundits expect to see those kinds of flows once the yield on the U.S. 10-year Treasuries rise past 3.5%. They are currently sitting at about 2.6%, which is 100 basis points higher than it was just six months ago.