How can investors seek to protect their portfolios from inflation?
In financial markets, if you anticipate a development, you anticipate, for example, inflation rising, the first thing you would do, you'd probably pull back on your duration a little bit and you would buy assets that tend to be, that tend to outperform in a cyclical expansion even as inflation starts to bubble up. So for example, treasury inflation protected securities, which are the rate of income that you receive is indexed to the level of inflation, so that should immunize you, if you will, in terms of the impact of inflation on your cashflow. Also, investors should be looking at fixed-income instruments that are outperforming as the economy does well. So that would be credit-oriented segments of the market, sectors like high-yield corporate, for example. Emerging markets would be another example. And within places like municipal bonds, bonds of mid and lower credit quality tend to perform better in a period of economic expansion with some inflation bubbling up. I think over time, it's important to realize the Fed's role here. It's fundamental.
If the Fed is seen as literally sitting on its hands and letting inflation overheat well beyond the levels that they intend, then shortening your duration is the right thing to do because long-term bonds are going to underperform, the yield curve will steepen. Long-term yields will rise more than shorter-term yields. The most recent development from the Fed, however, it's casting some signals that the Fed wants more inflation, yes, but they're not going to do so irresponsibly. They're not going to sit on their hands to the point of committing a policy error. That, as a result, they will tighten policy, not based upon forecast of inflation. They still want to see the real inflation emerge and they want to make sure it stays above two. That's their goal. They've said it over and over like a broken record. But as they see that inflation happening, if they begin to pull back monetary accommodation as the dot plot recently suggested, then long-term bonds actually can be much better performers in your portfolio. After that sort of initial reset higher in yields, if we think it's coming as the year winds down, then you probably don't need to worry as much about duration say in 2022 or 2023.
Disclosure: Views are as of June 22, 2021, and are subject to change based on market conditions and other factors. This should not be construed as a recommendation for any specific security or sector. Investments are subject to risks and fluctuate in value. Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices. Yield Curve is a graph showing the comparative yields of securities in a particular class according to maturity. Securities on the long end of the yield curve have longer maturities. Duration is a measure of a security's price sensitivity to changes in interest rates. Securities with longer durations are more sensitive to changes in interest rates than securities of shorter durations. Federated Investment Management Corp. 21-10102 (7/21)
Hello, I'm RJ Gallo, Senior Portfolio Manager, Federated Hermes.