Is Your Portfolio Prepared for Inflation & Interest Rate Uncertainty?

The future path of inflation, and consequently interest rates, remains highly uncertain. The Federal Reserve (Fed) has been unable to bring inflation down to its 2% target for over three years. In addition, global debt levels are at a historic high, which is likely to place upward pressure on interest rates.

Asi De Silva, CFA, Chief Investment Officer of Capital Squared Financial (CSF), shares some of the key factors to consider and potential portfolio strategies.

The uncertainty is driven by several opposing global macroeconomics factors

Inflation will fall

• The world’s population is aging and is expected to lower consumption and economic output. Japan’s economy is often sited as evidence of inflation ebbing as populations age.
• The world has record-high debt levels and servicing that debt is deflationary. The idea here is that cashflow will be used to repay debt instead of spending on consumption. This has so far not materialized among OECD government who continue to borrow record amounts and maintain deficit spending.
• Technology has been a source of deflation and Artificial Intelligence capabilities may accelerate this trend.

Rising Government Debt to GDP ratios

Source: Visual Capitalist

Inflation will remain elevated

• Global central banks created significant liquidity to fight Covid (and before that the global financial crisis). With the money still circulating in the economy, both consumption and asset prices are being driven higher. This activity has kept the job market firm and salaries strong, underpinning rising demand/inflation.
• Deglobalization and reshoring (bringing production back to the US) is inherently inflationary as we duplicate production and OECD economies have higher costs.
  
• The energy transition to renewable sources and electrifying transportation will also be inflationary. This activity will be particularly commodity and energy intensive.

BCG projects $37 trillion energy transition capital spending by 2030

Source: Bridging the $18 Trillion Gap in NetZero Capital, BCG November 2023

What are the main risks?

• Sustained high inflation will challenge future purchasing power of retirement portfolios. The challenge would be exacerbated if the composition of stock returns changes from tech to other areas because today’s broad indices like the S&P 500 are heavily exposed to technology.
• Retirement portfolios relying too heavily on bonds may struggle to provide inflation-adjusted purchasing power over longer periods.
• Will private investors demand higher interest rates to finance countries with rising deficits and debt service (interest payments) ratios? 
• In contrast, an economic slowdown (no such signs today) could pressure stocks while long-term bonds provide strong returns.

How can you mitigate some of these risks within your portfolio?

• Make sure you are truly diversified across many sectors. Today, Nvidia has a higher weight in the S&P 500 than the entire energy sector!
• Building a bond ladder for short-term income needs can help alleviate potential bond price volatility and provide a cushion to absorb overall portfolio volatility.
• Diversify bond exposure outside of bond ladders. Short-term bonds provide high current income and lower exposure to higher rates and inflation. However, If the economy slows, long-term bonds should provide price upside.