Unconventional Strategies for Inflation-Beleaguered Clients in the Retirement Zone
High inflation has taken the United States by storm, with the continued rise in prices becoming a source of stress for almost everyone. But this environment is all the more worrying for people in retirement or close to retirement as inflation diminishes the purchasing power of their hard-earned, but often limited, savings. After years of careful planning, the last thing retirees want is to miss their income needs due to the corrosive effects of inflation.
As people get closer to that age, their retirement accounts often become more conservative, relying on bonds to provide income, stability, and risk management. But the historic reliance on bonds for stability and the inverse correlation with equities can no longer be expected. Recently, bonds have fallen more than equities and their real return has been negative.
Moreover, rising interest rates virtually guarantee a bear market for bonds. The most recent of these markets lasted 36 years and had actual losses of over 50% when including the cost of ownership. This is partly because the Federal Reserve’s primary tool for fighting inflation is to raise interest rates, which can lead to principal losses and magnify real losses.
The last three instances of protracted inflation, which we define as periods when inflation rose by double digits in one year, resulted in average cumulative price increases of 101% and 29% loss of purchasing power in bonds. An additional concern is that high inflation globally has often been associated with high sovereign debt, much like the United States is currently experiencing.
Stocks are generally considered good hedges against inflation. However, according to a study conducted by my company over inflationary periods, stocks are usually hit at the onset of inflation, and only one of the three inflationary periods produced real gains. Taking these historic declines into account, equities have more or less kept pace with inflation during periods of high inflation and have not produced meaningful positive real returns, on average.
The stock and bond markets then seem vulnerable to sustained losses. Over the past three transitions from benign inflation to high inflation, stocks and bonds have been correlated to the downside. Investors don’t know what to do with their money when the old-fashioned idea of allocating to a balanced portfolio exposes investors to these correlated losses. You need growth to keep up with inflation, but risk is everywhere.
Accept the new reality
There is unlikely to be any good news for the markets unless the Fed backs down from its plans to continue raising rates – which would effectively just be more bad news from continued inflation. In the current climate, it is imperative to start looking at client portfolios and asking tough questions such as:
● Have I drifted too far into the “buy the dip” comfort zone?
● How vulnerable are my retired clients assigned to balanced strategies?
● How do I reposition myself for a bearish bond market?
● Is it time to reconsider the hedging strategies and tactics that have largely been abandoned since the great financial crisis of 2007-08?
The last question is particularly important, as the changing environment may require increased attention to protecting your investments. Investors should consider which strategies are best suited to manage the risk of stocks and bonds and how to select the best managers for those strategies.
Building portfolios for rising rates and inflation
Thinking unconventionally can win out in today’s market. Instead of abandoning stocks and bonds entirely, turning to investments that attempt to weather the eventuality of falling markets can allow investors to not only weather high inflation, but also thrive. .
First, change stock allocations to protect against market declines. Investors should maintain an equity allocation to fight inflation. But with high valuations and the potential for losses in the initial phase of rising rates, it is important to employ hedging strategies for some of this allocation. A potential solution is to allocate 50% of stocks to hedged equity funds or high-conviction tactical strategies that attempt to decorrelate falling markets.
By hedging portfolios against market declines, investors can maintain their stock allocation, but attempt to cope with high valuations and the reality that every period of high inflation over the past century has seen stocks plummet. the first years of rising prices.
Bond portfolios, especially for older or more conservative investors, should migrate to adaptive fixed-income strategies (such as tactical or unconstrained bond funds) that can tactically switch between short-term, high- performance or superior quality, or TIP. By migrating to these types of strategies, investors can maintain a balanced approach that may include a large equity allocation, but potentially reduce exposure to market downturns. We use the term “behavioral portfolio” to describe an all-season approach to market conditions.
There are several advantages to this structure. The first is that it satisfies the need for participation in stocks that will move with the market so that your clients feel part of the rising market. Another is to satisfy the natural desire to act when markets are uncomfortable while potentially protecting against market declines with risk-managed stocks. And the latter is taking advantage of changing bond conditions to seek opportunities while seeking to avoid real losses.
In a context of galloping inflation unprecedented for decades, people in retirement or close to retirement have every right to worry about the impact on their savings and their purchasing power. With little certainty about the future path of inflation, it makes sense for older investors to be proactive, carefully review their portfolios and possibly implement hedging strategies that could help protect their investments.