By Duane Ledgister, vice president, Connor Clark & Lunn Private Capital
Special to the Financial Independence Hub
Inflation has moved to its highest level in decades, with higher prices resulting from strong economic growth led by pent-up demand for goods and record levels of government spending.
At the same time, strong demand is leading to supply shortages. When we look at the components of inflation, we see recent price increases are largest in industries hurt the most during the pandemic, such as energy. These industries are cyclical and are pulling inflation readings higher as prices recover after a period of decline.
Higher prices in the short term are expected to be tempered as supply adjusts and demand returns to more normal levels, and while policy actions such as higher spending and larger debt levels have increased short-term inflation, the same forces are deflationary long-term. This is because more money goes to paying down debt as opposed to future investment. The caveat is that higher debt levels encourage policymakers to allow inflation to move higher than it has been in recent cycles. Accordingly, inflation will be higher but not at the disruptive levels we saw in the 70s and 80s.
Impact of inflation on your investment allocation
Now is a good time to consider its effect on different asset classes that make up a portfolio. Real diversification is much more involved today than you would have been told before.
Stocks can generally do well in a period of moderate inflation, whereas fixed income is hurt the most. Alternative asset classes — which most investors have little exposure to, and should begin evaluating — also have some natural protection from inflation.
Moderate inflation is a double-edged sword for stocks: increasing corporate cash flows while decreasing the real value of investment returns. Companies with high valuations tend to underperform as their valuations are based on future earnings growth long into the future. In a period of higher inflation, these future earnings are now worth less today. Companies with lower valuations, called value stocks, do better in a period of above-average inflation. Strategically it makes sense to hold both growth and value styles within your equity allocation.
The bond allocation of a portfolio is the one that is hardest hit by inflation, because most bond coupon payments do not increase with inflation, and bond yields tend to rise when inflation is moving higher. The result is both a temporary decline in the price of bonds and lower long-term real return. The negative effects of rising inflation and yields can be managed by holding short-term bonds and higher coupon bonds. The former is less sensitive to changes in inflation and yields. This protects capital when inflation is rising. The latter have more income to offset price declines.
Having a view of the economic backdrop and managing a bond portfolio’s sensitivity to changes in yields and inflation is important to delivering risk-adjusted returns, particularly true when inflation is on the rise.
This is where real diversification can pay off. The alternative asset classes in a portfolio are attractive since they generate strong levels of income relative to traditional equities and bonds. They also tend to be the least sensitive to risks in the broader economy, including inflation. Private market investments (real estate, infrastructure, and private loans) should have natural inflation stabilizers. For real estate, rental income tends to rise with inflation and infrastructure contracts may have ongoing inflation adjustments. Finally, private loans income rises as yields and inflation move higher.
Properly managed hedge strategies are a liquid alternative asset class. They don’t directly hedge against inflation, but when allocating to strategy within a portfolio, they are most effective when they are used to reduce bond exposure.
Plan for this changed investment environment
When reviewing your asset allocation, keep in mind that inflation does not affect all portfolios equally. More conservative investors with a larger percentage of their portfolio in fixed income are more susceptible to lower returns as inflation rises. Many of these investors who need their portfolios to provide income can least afford high inflation’s impact on risk/return. As such, it’s important to review the asset allocation on an ongoing basis and have a plan to see how trends like inflation may impact the ability of a portfolio to meet objectives.
Private market alternatives also can be a key tool in providing returns in a high- inflation environment. Smart institutional investors have been utilizing these options for decades. They are now accessible to private investors and provide true diversification beyond the traditional definition of a diverse portfolio that you may have heard about before.
Do your homework -it has never been more critical than in this changed investment landscape. Think: what do you need your portfolio to look like two or three years from now?
This post is for information only and is not intended as investment advice. The views expressed are those of the author at the time of publication and are subject to change at any time.
Duane Ledgister is Vice president, Connor Clark & Lunn Private Capital. He has close to 30 years of experience in the investment industry, working closely with high-net-worth clients to earn their trust, address their unique needs and surpass expectations. As vice president and wealth manager at Connor Clark & Lunn (CC&L) Private Capital, he prides himself on being a steward of client capital by providing premium diversification of ownership and investment solutions, to make his clients even more financially successful. An insightful, results-driven, and open-minded professional, Duane is a leader in the sea change within today’s investment community and is focused on providing outstanding value in his personal and professional relationships, with a focus is on diversity. His success and achievements are many, and his goal of diversification of insights provides better results and credibility, both in the community and the industry at large.
Before joining CC&L Private Capital, Duane held roles at Barometer Capital Management and 1832 Asset Management. Born in Montreal to parents of Caribbean descent and with roots in Toronto, he is committed to championing Black culture. His accreditations include a Bachelor of Arts- Finance & Economics degree from the University of Western Ontario and the Chartered Investment Manager (CIM) designation.
As part of his ongoing commitment to advocating BIPOC within the investment industry, Duane is a co-founder in the Black Opportunity Fund (BOF) and active member on its investment committee, to establish a sustainable pool of capital to fund Black-led businesses and Black-led not for profits and charities, to improve the social and economic well-being of Canada’s Black communities. His personal goal is to offer ongoing mentorship to younger graduates seeking guidance on navigating the industry in today’s current environment.
Duane feels passionately about supporting his community and serves on the Finance & Audit Committee of Ronald McDonald House Charities (National). Previously he has served on the Foundation Committee of Toronto’s Casey House and as a board member of the Canadian Foundation for AIDS Research. A keen snowboarder, Duane enjoys international travel, public speaking, and is passionate about contemporary Canadian and Black art and culture.