Why this is the time to inflation-proof your portfolio

Portfolio manager believes inflation is here to stay and that investments should reflect these risks

Why this is the time to inflation-proof your portfolio

News that Canada’s inflation rate rose to an 18-year high in September, driven by high gas prices, soaring housing costs, and rising food prices drew mixed reactions from two Canadian advisors – but the strongest advice was to use this time as an opportunity to inflation-proof your portfolios.

Martin Pelletier, a portfolio manager at Wellington-Altus Private Counsel in Calgary, told Wealth Professional he’s concerned about inflation, which has topped the central bank’s 1 to 3% control range for six consecutive months, because it could be around for longer than expected and derail government agendas not directed toward dealing with the cost of living crisis. He thought that crisis was only going to worsen, especially for the Greater Toronto Area and Vancouver, where housing prices are up and affordability is becoming a real issue for many.

He noted people’s perception of inflation may differ, depending on whether they’re participating in the housing rally in those jurisdictions, since they’re also seeing gas, electricity bill, and grocery price hikes.

“It’s very important that you reflect the dangers or risks of inflation in a portfolio,” said Pelletier. While many are worried about the market and valuations, “the longer you hold cash, the more damage it’s going to do to your portfolio, because inflation is going to eat away at that value since you’re not putting that cash to work. If you’re a GIC investor, it’s the same thing as cash because inflation is going to eat away at those investments’ value as well.”

The question then is, with markets setting new highs, where advisors should put that cash to work.

“The traditional 60/40 portfolio is being very challenged because if there is potential for rising rates, which I think there is, especially if inflation continues to run abated, then you’re going to see interest rate hikes and you could lose a lot of money on your bonds,” he said. “Bonds are not as safe an investment as they used to be, especially offsetting equities. You could see a market correction, and bonds go down alongside equities.”

Pelletier recommended looking at the cash, stocks, and bonds you’re holding and whether they’ll participate with, or be hurt by, inflation – which is where a portfolio manager’s research can help.  He said you can protect a portfolio by looking at the sectors that have a negative correlation to inflation. Technology, for instance, is very sensitive to interest rate hikes because it depends on low-cost capital. If the capital cost rises, then tech’s implied valuations decrease. So, technology stocks have a negative correlation with inflation and rising rates.

“Most of us probably have a big weighting in technology stocks,” he said, adding portfolio managers must do their research since not all tech stocks will be impacted by inflation. Some, like Amazon, “may actually be able to weather the storm because it’s really accelerating in this conversion digitization of the economy.”

On the flip side, the sectors that have a positive correlation with inflation, so will offset its impact, include oil and gas, agriculture, and even gold, which he said, “tends to do well at the beginning of the inflationary stage, but not as well toward the mid and later stages.”

“We also like value stocks. They’ve been out of favor for a decade, but they tend to be more resilient during an inflationary period and tend to get more attention,” he said. He also recommended structured notes as a partial fixed income replacement as “they have the potential to generate a higher yield in a rising environment, which is important because you don’t want to have a negative yield on your investment.

“So, you can tilt your portfolio and you don’t have to go all or nothing in positioning toward those sectors, but you can certainly increase the weighting. But, this is where you really get what you pay for when you have a portfolio manager versus a do-it-yourself scenario because an expert should be able to help mitigate some of those risks.”

Kristen Zubko, an Edward Jones financial advisor in Yorkton, Saskatchewan, sees this inflationary period as a time to educate clients about risk.

“When we think about risk, we think in terms of investments and their market fluctuation and the ability of our client to experience a decline,” she said. “We don’t often think about risk in terms of not taking on enough risk so that our investing will essentially keep up with inflationary pressure. The risk that our money will not buy what we need it to in the future is also a very pressing risk.

“That’s what I think of when I think of inflationary pressure. It’s something that I talk about with my clients every time, not just when it’s relevant, when we’re thinking about lumber and gas prices, which are very tangible experiences that our clients are having right now,” said Zubko, noting that Edward Jones builds this into its risk tolerance questionnaire and financial planning tool. “It’s a really good opportunity for us to educate our clients about inflationary pressure and the erosion of purchasing power and inform them about the types of investments they might want to consider.”