Risk vs. Inflation

Posted January 14, 2022

Inflation – CPI All Items Hits Highest Annual Rate of Change Since June 1982

On Tuesday, January 11, 2022, at the Federal Reserve Chairman Jerome Powell’s Senate confirmation hearing, chairman Powell called high inflation a “severe threat” to a full economic recovery and that the central bank was preparing to raise interest rates because the economy no longer needed emergency support. Mr. Powell went one step further and stated that he was optimistic that supply-chain bottlenecks would ease this year and help bring down inflation at the same time the central bank begins removing the emergency support.

The bond market began 2022 with a selloff that was further fueled by the Wednesday, January 5th release of the Minutes from the Fed’s December meeting which further increased the expectations that the Fed could start raising rates as early as March 2022. This was earlier than investors had anticipated. The 10-year U.S. Treasury yield closed the year at 1.496% only to see yields rally to a 1.769% close by Friday of last week marking the highest yield on the 10-year Treasury since early 2020, pre-Covid.

From the CPI All Items chart above, the 7% increase in December was up from 6.8% in November and marks the largest increase since the Reagan administration and the third straight month in which inflation exceeded 6%. All eyes are sure to remain on the Fed in 2022!  

So, what to do?

The problem is that investors are going to have an emotionally difficult time balancing their risk appetite with rebalancing their portfolios. To use our two sides of the investment coin analogy, we have risk on one side versus inflation on the other side. For investors who are worried about drawdown risks, moving to cash will be a guaranteed loss due to current inflation being higher than the rate of return paid on cash. Moreover, to fight inflation, investors will need to have equity exposure and exposure to other risk-on assets. You cannot fight inflation with risk-off assets.

To make matters more interesting, historically bonds would be a good diversifier to equities in times of volatility. However, bonds may be a poor diversifier to equities when inflation is high.

So, there is the tug of war. Do you manage risk or do you fight inflation?

As our team analyzes how to position our clients with regard to these competing market dynamics, we consider multiple solutions. A core part of our strategy is using Fixed Index Annuities as a bond alternative. For investment allocations, we look to our Focused Value and Focused Dividend strategies, Focused Real Estate, and increased exposure to energy. In the alternative asset space, we may include commodities and Focused Metals. These types of exposures are also available in our Sailboat asset allocation strategies. For accredited investors, our Energy fund and Equity fund could also be considered.

For investors, the number one thing we recommend is to implement a financial plan that is integrated with their investment policy statement. A sound financial plan is a foundation for successful downside planning. Finding an appropriate balance between cash, risk-off assets, and risk-on assets can be accomplished through your financial plan.

None of this is a surprise.

Markets ebb and flow, rates rise and fall, and market cycles are necessary for a healthy economy. The core philosophy and guiding principle of Sound Planning Group is that we don’t just want to have a pie chart, we need a real plan. If there is a problem with an airplane, the time to fix it is not at 30,000 feet. In the same way, our CPR (the right balance of Cash, Protection, and Risk) strategy was built not just to thrive when things are good, but to provide stability and confidence regardless of the economic and financial storms that arise.

As always, we will continue to manage dynamically with a mathematical, repeatable, and unemotional process. When new data presents itself, we will adapt and recalibrate our investment strategies as necessary. If you have any questions, please do not hesitate to contact us.

Joe Maas, CIO | CFA, CFP®, ChFC, CLU®, MSFS, CVA, ABAR, CM&AA, CCIM
David Stryzewski, CEO | CSA, NSSA