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How Will Inflation Impact Your Portfolio?

How Will Inflation Impact Your Portfolio?

March 24, 2021

US core inflation will likely be volatile in 2021 as the economy recovers from the pandemic. The Federal Reserve updated their projections at last week's FOMC meeting to 6.5% GDP growth and 2.4% inflation in 2021. Additionally, there is a $1.9 trillion US stimulus program under way and a $3 trillion infrastructure plan under consideration. As inflation expectations grow, many investors are concerned about the potential impact on stocks. 

There can be positive and negative implications of increased inflation for investment assets. Inflation can increase earnings and revenues in businesses that are able to offset higher costs with price increases. However, inflation also erodes the real value of investment returns. If inflation leads to higher interest rates, it increases the discount rate used to calculate the present value of future cash flows. A higher discount rate could cause investors to devalue assets with future cash flows. How inflation affects a particular asset depends on the net impact of those to factors - increased cash flows vs. higher discount rates.

Historically, the relative performance of different asset classes has shifted based on the inflationary environment. The below chart from JP Morgan illustrates four different scenarios: high and rising inflation, high and falling inflation, low and rising inflation, and low and falling inflation.

Source: J.P. Morgan Asset Management. *High or low inflation distinction is relative to median CPI-U inflation for the period 1988 to 2020 (33 years), which was 2.5% y/y. Rising or falling inflation distinction is relative to previous year CPI-U inflation rate. Indices: Bonds – Bloomberg Barclays U.S. Aggregate; Cash – Bloomberg Barclays 1-3 Month T-Bill index since its inception in 1992 and 3-month T-Bill rates prior to that; U.S. high yield – Bloomberg Barclays US Aggregate Credit (corporate high yield); Equities – S&P 500; Growth – Russell 1000 Growth; Value – Russell 1000 Growth; Small Cap – Russell 2000; EM equity – MSCI Emerging Markets (USD); REITs – FTSE Nareit / All Equity REITs; Commodities – Bloomberg Commodity Index since its inception in 1992 and S&P GSCI prior to that; Gold – NYM $/ozt continuous future closing price. For illustrative purposes only. Past performance is not indicative of comparable future returns. Returns are based on calendar year performance and are total return unless otherwise specified. Guide to the Markets – U.S. Data are as December 31, 2020.

In 2020, we were in a low and falling inflation environment in which growth equities performed well. Going forward we could be in an environment in which inflation is low and rising, in which case the relative performance of value and emerging market stocks could increase. Potential outperformance could be driven by attractive relative valuations combined with strong earnings growth. The relationship between value outperformance and inflation can be seen here. This chart looks at value vs. growth performance alongside 5-year, 5-year forward inflation expectations.

The key takeaway is that inflation is likely not detrimental to future stock returns. However, it may be prudent to make adjustments to your portfolio based on the inflation sensitivity of different asset classes. We always advocate for proper diversification across asset classes but making tactical changes can help position portfolios for a changing environment.

If you would like more insight on how to construct your portfolio in the current environment, schedule a meeting with one of our advisors.