The Federal Reserve struck a big blow yesterday in its attempt to bring inflation under control. Their monetary policy was to increase the benchmark interest rate by .75% now and likely another .75% next month. The Fed expects with these increases, the economy and inflation will start to slow. US inflation now is the highest in 40 years.
Neither the Fed, nor anyone else, knows exactly how this will play out. We hope the Fed can reduce inflation and bring us in on a “soft landing”- that comes with a tolerable amount of pain. But recession is a possibility (and the market has already “baked in” a 40% likelihood of that happening). In addition, some others feel that what we might be looking at stagflation, like America experienced in the 1970s.
Stagflation is a mashed-up term combining stagnation and inflation. It describes an economy that is not performing well, where prices are high and economic growth low. This is what happened in the 70s when inflation averaged 7.4% per year and the S&P 500 returned 8.5% per year. Compare that to the favorable environment in last full decade- 2010 to 2019- when inflation averaged 2% per year and the S&P 500 returned 16% per year.
Of course, most all of us want low prices and a booming economy. We like things to go up. In short, most of us have had it very good since the Great Recession in 2008-09. Even 2020 and 2021 were amazing years, with inflation averaging “only” 4.2% per year and S& P 500 returns at 22% annually on average, despite Covid’s presence for almost the entire period. The end of 2021 marked the third year of expansion with low inflation. There was lots of money created, particularly through stimulus programs, and lots of debt taken on. Add in COVID, the war in Ukraine, and now “deglobalizing” (as the US and other countries bring jobs back home) and the current situation is no surprise.
Asset valuations are facing big headwinds from inflation and a possible slowing of the economy. So, what is an investor to do? What is your investment policy and plan? For most investors, all cash is not an option. Bridgewater CEO and author Ray Dalio puts it this way, “Cash is trash.” Inflation eats up the purchasing power of your money. So, what might an investment policy look like to produce a decent return, based upon your risk profile with minimal risk, not only for the market today but the possibility of recession or even stagflation?
Let’s first look at the asset classes in both high and low inflation and high and low growth. Certainly, equities fare well when inflation is low and growth is high. Fixed income, historically, has done well also in that environment. A “typical” portfolio” of 60% equities and 40% fixed income, has done well for the last 30-40 years. Many portfolios, including 401ks, have maintained a “typical portfolio” for decades, with the equity portion varying based on the risk profile of the investor.
However, in times of high inflation, equities and fixed income become closely correlated- both perform poorly. While we all know that equities are down 20% or more in 2022, many don’t realize that according to the AGG, fixed income is down 12% year to date. Fixed income is no longer your “grandfather’s fixed income.”
What many portfolios lack is the one asset class that tends to do well. That asset class is alternatives, particularly commodities and managed futures. Alternatives, by definition, are holdings and strategies that have different behavioral traits than equities. Alternatives are close to break-even for 2022 and commodities are up significantly. One commodity index, the S&P GSCI index, is up 46% in 2022. Alternatives should be in your portfolio both now and for the future. The exact asset allocation in your Investment Policy is customized for you and starts with asset allocation.
Diversification is also key. Within each asset class, it is important to have exposure from a number of appropriate styles. Take equities, for example. The S&P 500 has been the place to be the last 12 years, with returns of about 17% per year. But many folks forget that 2000-2009 was the “lost decade” for the S&P 500, when returns, on average, were flat. Valuations, particularly of the largest companies, in the S&P 500 soared up to December 31, 2021 and now in 2022, as valuations start to “right size,” the S&P 500 has lost more than international and emerging market stocks. Diversification holds true for fixed income and alternatives as well.
CONCLUSION: No one knows the future. We do know that the Fed will continue to apply monetary policy in its fight to reduce inflation, hopefully with a soft landing, without creating a recession or stagflation. In the meantime, most of us need and/or want to be invested. Cash is not an option for most. If you don’t have alternatives, consider adding them. If you do have alternatives, consider increasing their allocation. Work with your adviser and determine an appropriate, diversified asset allocation within your investment policy that you can live with and have peace of mind. Stay invested and let your investment policy and the markets work for you to match and then beat inflation.