The investment world is changing, and many investors, particularly those in passive or traditional 60/40 portfolios, are not prepared for what is on the horizon. Thankfully, there is still time to prepare.
1. Get genuinely diversified
The first thing is to ensure that your portfolio is properly diversified and holds assets fit for the next decade. Generally, equities thrive in booms and bonds thrive in busts, the traditional 60/40 portfolio offers little hope of outperforming cash in a stagflation scenario.
However, there are some healthy alternatives. Investments in inflation-linked bonds and commodity-related securities can provide a hedge against inflation. With markets pricing benign inflation of just 2% for the foreseeable future, higher inflation is not priced in, so inflation-linked bonds offer good insurance.
Infrastructure assets can also provide protection. Infrastructure companies, such as pipeline operators, own physical assets that other companies have to use. This gives them significant pricing power, enabling them to protect their cash flows against rising consumer prices.
Gold, of course, is the classic asset to hold during times of stagflation. Central banks cannot print it, and with inflation hurting bonds and poor growth hurting stocks, the opportunity cost of holding gold dwindles, boosting its price.
Finally, relative value within equities can be a rewarding exposure during periods of stagflation. By purchasing shares of companies likely to thrive and hedging out broader stockmarket indices, investors can reduce their dependence on overall market movements, and generate positive returns if their selected stocks beat the S&P 500 or FTSE 100.
2. Buy cheap and undervalued assets
Another critical step is to diversify across styles within equities. Though markets in aggregate are expensive, they are not uniformly expensive. While many investors are familiar with the cycle of broad asset prices and interest rates, there is an equally important cycle unfolding at the same time—the cycle in valuation gaps.
When money is cheap, asset prices rise, and the prices of speculative assets rise the most. That channels money to wasteful places, which drives inflation, and ultimately prompts higher interest rates. The resulting downcycle is unpleasant for passive investors, and painful for those holding the most expensive assets. But there are cheap assets, too—the companies that were neglected during the euphoric easy money times.
Historically, simply holding stocks at low price multiples made a transformative difference to investors’ returns during downcycles compared to having expensive assets (see below). Active managers can do even better—there are thousands of stocks in world markets and hundreds trading at low price multiples. They only need to find a few dozen that are attractively priced.
3. Blend good active managers with different styles
Finally, investors should look to blend good active managers with different styles within their portfolio. 2022 was a prime example of how costly it can be to hold multiple active funds with the same growth style. Even if an investor had 50% of their portfolio invested in growth-style funds and 50% in passives, that portfolio would have suffered greatly when growth (and increasingly growth-heavy passive) funds fell out of favour. An investor holding that mix would have seen a drawdown of 22% and would still be down 14% today.
