The US Federal Reserve’s (Fed’s) message on inflation is clear: Higher domestic inflation is likely in the period ahead, but it should be “temporary” in nature. This begs several questions, among them: What exactly does “temporary” mean? Which price increases, if any, could be longer lasting? And if higher inflation proves to be “stickier” than anticipated, how should investors position their portfolios?
The Fed’s latest forecast is for the Consumer Price Index (CPI) to rise to 2.6% this year (which it already hit in March), before settling back down to just over 2% in 2022 and 2023. Likewise, market expectations (as observed in recent “breakeven” inflation rates) are for US inflation to pick up in the near term and then come down longer term. Yet I am hearing from some of my analyst colleagues that many areas of the economy are facing stubborn supply shortages and upward price pressures, including freight, semiconductors, housing, raw materials, and labor.
Thus, in my view, the risk is that higher inflation may have a longer-than-expected “tail” before normalizing, or perhaps a more enduring structural component.
Inflation, housing, and rents
One area where prices have certainly risen is in the housing market. Year over year, US existing-home prices were up a record 17% as of March 2021. Equally important, but less discussed, is how higher home prices might feed through to “rents and shelter,” the largest category in the CPI and one of the largest in the Personal Consumption Expenditures (PCE) Price Index (the Fed’s preferred inflation measure).
Figure 1 shows the surge in home prices and the accompanying collapse in rents when demand for space soared amid the pandemic, while inventories were tight and mortgage rates low. Notably, “shelter” costs have just recently inched up and have historically lagged home prices by around 18 months. If rents follow home prices as in the past, then rents could rise further and may also benefit from some shift back from “working remotely” as workplaces reopen.
While the relationship among rents, home prices, and broader inflation is inexact at best, a turning point in rents is a potentially big deal for both the CPI and the PCE. It is also likely to matter to markets and could stoke greater inflation volatility, if not a longer “tail” to higher inflation than the Fed and investors currently think.
- The length of the inflation “tail” is a wild card. While near-term inflation looks poised to climb, there could be a longer “tail” to higher inflation than markets seem to expect — in the form of rising rents, for example (as noted above).
- Investors should seek inflation protection for their portfolios. Effective inflation hedges may include commodities, equities, real assets, and fixed income:
- Commodities exposure in natural resources, agriculture, and industrial metals tends to be the most inflation sensitive.
- Consider more value-oriented, cyclical equity sectors, such as energy, financials, materials, and some industrials.
- Some companies will face profit-margin pressures. Thus, a key attribute to look for in any company these days (regardless of sector) is pricing power.
- Real assets and some equity real estate investment trusts (REITS) could provide another source of inflation protection.
- In fixed income, I believe short-duration Treasury Inflation-Protected Securities (TIPS) are likely to outperform nominal US Treasuries.
- Duration: Shorter is better. While I still expect high-quality bonds to confer diversification benefits in the event of an equity sell-off, shortening fixed income duration to guard against an inflation-induced spike in interest rates might be a prudent move.