Last week, I shared some somber news with you…
It’s looking more and more likely that we’re headed for stagflation – an economic environment where we see high inflation and a weak economy at the same time.
This is a relatively rare situation. We haven’t seen anything like it in the U.S. in nearly 50 years. But the warning signs are unmistakable.
One the one hand, inflation is higher than it’s been in decades. And several structural issues – including ongoing supply chain disruptions, geopolitical conflict, and long-term underinvestment in energy, among others – suggest it’s unlikely to return to reasonable levels anytime soon.
On the other, we’re already seeing some early warning signs that often precede a recession. These include signs of weakness in the housing and credit markets, a potential slowdown in the transportation sector, and “inversion” in the Treasury market yield curve.
We received further evidence of this trend this week. On Thursday, the government reported the U.S. economy – as measured by gross domestic product (“GDP”) – unexpectedly shrank by 1.4% over the first three months of the year.
Even more concerning, this is occurring before the Federal Reserve has really started raising interest rates in earnest. If the Fed actually follows through with its current tightening plans, a recession could be unavoidable.
Given these risks, I believe it makes sense to start preparing your portfolio for stagflation.
Fortunately, as a Money Talks reader, you should already be better positioned than most investors. As I explained last week, that’s because the inflation-investing guidelines I shared with you last month generally apply in a “stagflationary” market environment as well.
In short, this entails avoiding investments that tend to perform poorly in inflationary investments while focusing on those that tend to perform well.
Let me share a few examples.
The former includes bonds, most technology and growth stocks, and large amounts of cash. The investments that tend to do better include commodities and commodity-producing stocks, dividend-paying stocks with pricing power, cash-flow-producing real estate and real estate investment trusts (REITs), high-quality value stocks, and emerging markets stocks.
However, I also told you I would share a couple of simple “tweaks” to these guidelines to help you protect yourself from the risk of a weakening economy, too.
The first, and most important, has to do with cash.
As I mentioned last time, I believe it’s prudent to hold some cash even when inflation is high.
This may sound counterintuitive – after all, when inflation is high, every dollar you hold in cash is literally losing purchasing power every day. However, cash also gives you “optionality.”
Holding cash gives you the ability to weather volatility, handle emergencies, and take advantage of buying opportunities in other assets that you can’t get anywhere else.
This optionality is valuable even when inflation is high. But I believe that’s doubly true during periods of economic weakness, when market volatility, financial problems, and tremendous bargains are more common.
So, my first suggestion is to increase your cash holdings a little more than I recommended in those earlier guidelines.
As always, I’m unable to provide individual investment advice in this column. And frankly, I don’t know enough about your financial situation, investment horizon, or risk tolerance to do so even if I could.
However, generally speaking, I think holding somewhere between 20% and 30% of your total portfolio in cash is a reasonable range to consider.
If you’re an aggressive investor with decades until retirement, you may prefer to hold less. If you’re more conservative or closer to retirement, you may wish to hold even more than I’ve suggested.
And again, you can “hedge” this position against the risk of severe inflation by holding some gold – and perhaps a little bit of bitcoin (BTC/USD) – along with it.
My second suggestion is to further scale back risk by focusing on the safest possible investments within those inflation-friendly assets I mentioned earlier.
You see, in a strictly inflationary environment, just about any commodity-producing company can do well. In fact, you’ll sometimes see weaker companies (with more debt, higher capital costs, lower margins, etc.) outperform stronger companies due to their higher built-in leverage to commodity prices.
But that isn’t necessarily the case in a stagflationary environment. When operating conditions are more difficult, business quality becomes much more important.
For example, if you’re investing in oil producers, you might focus primarily on dominant blue chips like Exxon Mobil Corp. (XOM) and Chevron Corp. (CVX).
By definition, these companies don’t have the same long-term growth potential as smaller, less established companies. But they’re still well positioned to benefit from higher energy prices, and they’re far safer to hold if the economy begins to slow.
The same logic applies to investments in the other assets I mentioned, including companies with pricing power (consumer staples, health care, and some mature tech stocks), REITs, and value stocks.
The one exception is emerging markets stocks.
Many emerging markets are commodities exporters that tend to benefit from higher inflation.
However, they also tend to be more sensitive to economic weakness. When developed economies like the U.S. or Europe slow down, emerging market economies can be crushed.
Given the growing risks of a recession, I would recommend everyone but the most aggressive investors avoid investments in these stocks today.
These “tweaks” are relatively simple, but they could make a big difference in your returns – and help you sleep well at night – if stagflation rears its ugly head this year.
To help you get started, I’ve included an example portfolio – built with our Pure Quant portfolio-builder tool – below.
Each position is a healthy stock from a healthy, inflation-friendly sector that meets two or more of our proprietary TradeSmith strategies, including Best of the Billionaires and Dividend Growers. Several are also members of the S&P 500 Dividend Aristocrats, an exclusive list of blue-chip companies that have increased their dividends for at least 25 consecutive years.
I’ve also included the risk-adjusted position size for each stock, and the number of shares of each for a $10,000 investment portfolio.
If you have any questions or comments on today’s editorial – or any previous Money Talks topics – you can always reach me directly at [email protected]. I can’t respond to every email, but I read them all.