In 2021, U.S. investors experienced a phenomenon they hadn’t seen in 40 years: high inflation, which rose 9.1 percent, year-over-year in June.
Uncharacteristically, this dramatic rise in prices came amid slowing economic growth. Data released in July confirmed the U.S. economy just experienced two consecutive quarters of negative GDP growth, which meets the technical definition of a recession, even though inflation-adjusted consumer spending is roughly flat and the job market remains strong.
Regardless of the debate around whether the U.S. is already in a recession, the combination of higher prices and slower growth, termed “stagflation”, should prompt investors to consider potential adjustments, which might include:
Asset Diversification Across Economic Drivers
Many portfolios are positioned to prosper during boom times, with little consideration given to periods of economic malaise. Diversifying beyond stocks, which form the backbone of the average investor’s portfolio and are highly correlated with global growth, might provide important benefits such as lowering portfolio volatility and improving risk-adjusted returns. This diversification can include:
1) Owning Commodities: Commodities are one of few asset classes to produce positive returns in 2022. Commodities typically behave cyclically, experiencing booms alongside global economic growth and busts during slowdowns. Today, supply-side constraints resulting from structural underinvestment have improved the return outlook for commodities despite slowing global growth.
2) Owning High-Quality Fixed Income: Fixed income has a long track record of effectively diversifying stocks due to their low return correlations. This is particularly true in risk-off market environments. Should recession concerns outpace inflationary ones, we would expect the Federal Reserve to pause or even reverse recent rate hikes to help re-ignite economic growth. When interest rates decline, sovereign debt and high-quality corporate bonds have historically benefited and are preferable to gold or cash as alternative safe-havens.
3) Owning Value Stocks: Value stocks outperformed Growth stocks in the 1940s, 1970s, and 2000s, all decades characterized by above-average inflation. Meanwhile, low inflation regimes in the 1930s and 2010s saw Growth outperform Value. We’ve already seen U.S. Value beat U.S. Growth by nearly 10 percent year-to-date. Value’s lower valuations and higher dividend yields continue to make it stylistically attractive relative to Growth.
Investing vs. Maintaining Cash
It may seem enticing to hold more cash in an economic slowdown, but elevated inflation will erode the purchasing power of cash much faster today than in the past. “Timing” the market with respect to re-deploying sidelined cash can also result in missing market rebounds, which tend to happen in close succession with drawdowns.
Look Beyond Market Corrections to Take a Long-Term View
Despite the challenges presented by the macroeconomic environment, investing in a diversified portfolio has proven to be a resilient strategy time and time again. Since 1950, there have been 24 market corrections, and roughly 80 percent of those corrections recovered in less than two years. Long-term investors require that their portfolios perform over decades, not years. Those decades will bring varying macroeconomic and geopolitical shifts, making diversification across low-correlated asset classes important to achieving acceptable risk-adjusted returns.
In today’s low growth/high inflation environment, investors may benefit from non-correlated diversification, select tactical portfolio tilts, and remaining invested rather than moving to cash both to avoid losses and principal erosion during periods of high inflation. Individual investors should consult a knowledgeable financial advisor to ensure any strategy is well aligned with their unique financial situation.
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