Inflation Could Stick Around Much Longer. What to Do About It.

Tensions in the Middle East and a still strong economy make the case that inflation could stick around, delaying interest rate cuts by the Federal Reserve.

Investors may want to use any uncertainty over geopolitics or the Fed’s next moves to snap up potential hedges. Stocks slipped Monday as investors digested what President Joe Biden described as Iran’s “unprecedented” attack on Israel over the weekend and retail sales came in stronger than expected.

---

---

While efforts by leaders to maintain some semblance of stability in the Middle East could alleviate near-term market pressure, the level of military activity in the region—and the war in Ukraine—could continue to support commodities prices, said Robert Teeter, head of the investment policy and strategy for Silvercrest Asset Management Group. “The backdrop of continued geopolitical stress is contributing to more persistent inflation and more caution on valuation,” Teeter added.

Louis-Vincent Gave, head of Gavekal Research, has been stressing to clients for a while that inflation is unlikely to abate—and they may want to rethink what assets can provide protection. The U.S. dollar and Treasuries, traditional havens, haven’t offered as much as a buffer as gold since Russia invaded Ukraine two years ago.

“The world has now moved into an inflationary boom,” Gave wrote in a note on Monday. “In a world in which growth is humming along, most Western governments have lost all pretense of fiscal discipline, geopolitical risk threatens to derail markets, and in which inflation remains far above average for the past couple of decades, the only two genuinely anti-fragile asset classes are precious metals and energy.”Gave’s advice is that investors may want to capitalize on any short-term pullback in energy and metals. The SPDR S&P Metals & Mining ETF is up 7% over the past three months.

Even before this weekend’s developments in the Middle East, a batch of U.S. economic data showed a still hot economy. That pushed strategists toward a “no landing” scenario in which the Federal Reserve ends up not cutting interest rates at all this year—down from earlier expectations for six rate cuts.  

If there is continued strength in payroll data and the consumer price index, Michael Hartnett, chief investment strategist at BofA Research, tells Barron’s that interest in commodities—metals and energy—is likely to increase.

Industrial metals like copper, he says, benefit not just from the inflationary backdrop but also increased demand from an artificial intelligence revolution. Energy is linked to geopolitics and gets a bit of an AI boost, he adds.

DataTrek Reseach Co-Founder Nick Colas also favors energy for those worried about inflation or a geopolitical flare-up spoiling the economy’s recent Goldilocks phase. It is one of the sectors that has reliably worked as a hedge. Plus, accounting for just 5% of the S&P 500, owning a bit more than the index as a hedge won’t hurt much if it turns out the protection wasn’t needed, Colas adds.

While both Hartnett and Colas expect technology stocks to hold up broadly in a no-landing scenario, that could change later into the year. If it becomes clear the Fed isn’t going to cut rates, Hartnett sees a potential selloff in the heavily-owned sector and investors pivoting toward more of a defensive playbook that would include bonds.

Within bonds, Anders Persson, head of global fixed income for Nuveen, tells Barron’s he has been tilting toward floating rate opportunities in fixed income, especially senior loans. Yields are a draw, with senior loans paying roughly 9.6%, compared with 8% for high-yield bonds, and 5% from investment-grade bonds.

“So far, we are seeing inflation holding up and rates going higher, primarily because the economy is holding up better-than-expected,” Persson says. “That means credit fundamentals are holding up better so our concerns around default rates are pushed out and we are more comfortable reaching for that extra yield.”

There are two other areas in fixed income Persson favors on the view inflation may be stickier. One is collateralized loan obligations, which are made up of senior loans and are floating rate. The other is preferred stocks that have a duration of three to four years, shorter than investment-grade bonds, making them less vulnerable to higher rates.

Persson stresses selectivity, sticking with higher-quality issues and more liquid securities so he can be nimble if the economic backdrop changes or geopolitical situations cause a flare-up and lead investors to dump riskier assets.

Between the risks of more geopolitical tensions and the conundrum facing the Federal Reserve about interest rates, adding some protection on the margins to portfolios—especially if it goes on sale—is appealing.

Write to Reshma Kapadia at reshma.kapadia@barrons.com