Inflation that reached four-decade highs in 2022 contributed to bear markets in stocks and bonds. Although inflation is slowing and markets have rebounded in 2023, demographics and climate change are among the factors likely to prevent inflation from staying consistently in check. Consequently, the portfolio strategies that worked well during recent decades in which inflation was well contained may require adjustment for an environment that features more persistent periods of above-target inflation.
Changing demographics play a role in inflationThe aging population dominates most discussions about demographics. However, population composition may be a more powerful factor influencing the future path of inflation.
Research from TS Lombard’s Dario Perkins suggests that the combination of retiring Baby Boomers and younger workers will contribute to inflation remaining above the Fed’s targets. According to Perkins, “A population in which everyone is middle-aged will be more disinflationary than a population stacked with younger or older groups.”
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With the U.S. population skewed toward younger workers who tend to be net borrowers and retirees who spend down accumulated savings during retirement, the disinflationary experience of the past several decades is likely to come to an end. Although the experience of Japan contributes to the perception that aging demographics are inherently deflationary, the population composition of Japan differs significantly from that of the U.S.
Japan’s elderly population has grown over the past three decades; however, its aging population has been offset by the equally dramatic decline in the portion of the population that is young. Perkins notes, “The balance between the high-inflation groups and the low-inflation groups has, in fact, been quite stable since the early 1990s.”
How climate change and decarbonization contributeClimate change is likely to be inflationary, with heat waves, droughts, wildfires and storms contributing to future supply shortages. Geopolitical conflicts may also be a source of supply disruptions, as was the case in 2022.
The climate transition may create more common spikes in fossil fuel prices, with weak conventional oil capital expenditures likely to keep oil prices high. Refinery capacity-driven supply squeezes are a risk, as the push to decarbonize will limit the amount of investment in refinery capacity.
Although alternative energy capital expenditures will be strong, it will be difficult for alternative energy to ramp up fast enough to meet climate targets, increasing the years in which duplicative supply is needed to complete the energy transition.
Long-term portfolio strategies to considerThe “new normal” for inflation may be above 3%. With inflation a more persistent threat to returns and monetary policy moving from a loosening to a tightening bias, bonds may not be as consistent a hedge against falling stock market prices.
In addition, with bonds still at tepid yields relative to inflation, income-focused investors may need to supplement traditional bond holdings in the search for yield. Consequently, the oft-heard advice to “stay the course” may be inappropriate for the environment of the coming decade. Long-term investors should think about making “course adjustments” to add investments that provide incremental diversification, inflation protection and/or incremental income:
1. Real estate/real estate investment trusts. Core real estate provides income and potential for capital appreciation. Residential REITs may offer solid protection against inflation, with rent growth likely to outpace inflation thanks to chronic housing underbuilding and growth in household formation. Industrial REITs may also offer inflation protection as companies are shifting away from the “just-in-time” to “just-in-case” models, spurring strong demand for warehousing, fulfillment and logistics centers.
2. Infrastructure. Toll roads, airports, bridges, utilities and cell towers are among the investments that offer steady cash flows that adjust upward over time. Infrastructure investments typically benefit from barriers to entry and offer predictable cash flows that adjust upward over time.
3. Farmland and timberland. Farmland benefits from population growth and reduced arable land; productivity improvements improve crop yields. Farmland is a good source of income and portfolio hedge against rising food costs. Timberland pricing historically has been positively correlated to inflation and timber may benefit in the aftermath of a decade of underinvestment in housing supply.
4. Treasury inflation-protected securities (TIPS). TIPS are indexed to the consumer price index (CPI), providing protection against rising inflation. Shorter-term TIPS may be preferable to longer-term TIPS, as oftentimes, interest rate movements on longer-term TIPs can more than negate the inflation protection when rates move significantly higher.
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