Market Matters for August 12, 2014

Below is a weekly update from our Chief Investment Officer, Dr. Scott Lummer. He co-hosts an audio segment entitled “Market Matters.” In this week's show, Scott discusses the impact of inflation on investors. He analyzes the impacts of inflation on both equities and bonds, differentiating between various types of bonds. He describes why inflation has a greater impact on retirees, and provides specific strategies that investors can use to protect their portfolio against the impact of inflation. Each week he covers a different piece of investment news focusing on recent events in the capital markets, and relates them to Savant Investment Group’s perspective on investing.

Episode Transcript

Daphne: Welcome to Market Matters, a weekly discussion about investing in today’s capital markets. I’m Daphne Feng and, as always, I’m joined by the Chief Investment Officer of Savant Investment Group, Dr. Scott Lummer. Scott, I know one key economic indicator you focus on is the inflation rate. How does inflation affect investors?

Scott: There are two impacts of inflation to consider – the effect on portfolio values, and the effect on portfolio needs. The effect on needs is particularly important.

Daphne: Are there types of investors for which the effect on portfolio needs are particularly important?

Scott: The most obvious group are retirees because they aren’t going to make contributions to that portfolio. So an inflation increase means the retiree’s needs will go up, without a possibility to adjust contributions.

Daphne: Won’t inflation also affect portfolio needs for people who are not yet in retirement?

Scott: Yes, but they are still able to make contributions to their portfolio. Moreover, at least in theory, their salaries should be going up as well because of inflation. That might mean they are able to make more contributions without affecting their lifestyle.

Daphne: What about portfolio values?

Scott: Inflation will affect various components of a portfolio differently. The most obvious impact is on bonds. When inflation picks up, interest rates naturally rise, because investors demand a higher interest rate to compensate them for the loss of purchasing power. Hence, values on bonds will tumble.

Daphne: Does inflation affect all bonds equally?

Scott: No. It will affect longer term bonds the most, because the farther out the interest and principal payment on the bonds, the more their purchasing power is diminished. That is why we seldom don’t recommend long-term bonds for most investors’ portfolios.

Daphne: What about stocks?

Scott: In theory, stock market values are impacted by current and future expected company profits. So inflation should not impact the overall stock market because inflation affects both corporate revenues and expenses. As long as inflation is moderate, inflation might actually be good for stocks, because slightly higher inflation rates are typically associated with higher economic growth.

Daphne: So inflation is not bad for the stock market?

Scott: Again, as long as inflation is moderate. Over the past 30 years, stock market returns have been higher during periods of higher inflation than lower inflation. But, inflation has never been more than 6% over the past 30 years.

Daphne: You have qualified your answer a couple of times, as long as inflation is moderate? What if inflation is high?

Scott: In 1973 because of the Arab Oil Embargo, and in the late 70s because tensions in Iran, oil prices shot up, causing double digit inflation in the U.S. Such a rapid increase in prices is bad for the economy, so in those cases the stock market declined in value. However, it’s unlikely that we will see anything near those inflation levels in the foreseeable future. So at present levels, stocks seem to be a good hedge against inflation.

Daphne: So it seems that one way to protect against inflation is to have a large allocation to stocks.

Scott: That’s right. But that makes things very difficult for retirees. As we discussed before, they have the greatest need to protect their portfolios from inflation, which would suggest they should have a lot of equities. But they are also concerned about overall volatility, and stocks are much more volatile than bonds. That puts them in a difficult position

Daphne: So how should retirees protect themselves for inflation?

Scott: There are four things retirees should consider. First, they need to have some allocation to equities, even though they’re more volatile – some equities are needed for growth and an inflation hedge. Second, their bond portfolio should be diversified across different types of bonds – Treasury bonds, investment grade corporates, high yield, even some emerging market bonds, and maybe some municipals. Third, they should have a portion of their portfolio in short-term bonds – the prices of those bonds do not fluctuate as much with inflation. Finally, in doing retirement planning, they should factor in a cushion to allow for a rise in inflation.

Daphne: I’m surprised you haven’t mentioned TIPS – or Treasury Inflation Protected

Securities.

Scott: The concept of TIPS is ideal – to provide bonds with low credit risk because they’re backed by the government but provide greater principal if inflation increases, thereby stabilizing the volatility of the bond. However, the mechanism through which they supposedly keep pace with inflation seems less than satisfactory. There are times when TIPS have had greater volatility than corresponding Treasury bonds. I feel more comfortable using shorter maturity bonds than TIPS.

Daphne: And that’s Market Matters. Thank you Scott and thanks to all of you for listening. Please join us next week when Scott and I will talk about indexes.

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