Inflation glass half full: expert

Statistics Canada’s recently released inflation figures are a mainly positive sign both for the Canadian economy and investors, suggests Serge Pépin, head of investments at BMO Investments Inc.

“There’s a good side and a bad side to inflation,” he said. “When inflation is rising, it usually means there’s good economic growth behind it, so you always want some inflation in the system. You just want to make sure you can manage and control it so it doesn’t run off the tracks.”

Pépin expects headline inflation to hit 4%, which is still relatively low compared to some other countries. With core CPI at 1.8%—just shy of the Bank of Canada’s 2% target—it’s likely we’ll see incremental interest rate tightening come September.

“I tend to see the glass half full as opposed to half empty. I look at this as being relatively positive for the Canadian economy and for investments as well,” he said.

Portfolio adjustments

Pépin suggests there are several options for investors looking to hedge against inflation risk.

The rise in inflation has been driven to a considerable extent by higher commodity prices, “so why not have exposure to that? We’re in an extremely good situation here in Canada, being a resource-based economy where there are several options for getting that exposure.”

He also pointed to financial services as a good place to park investment dollars when interest rates are likely to rise. “Banks make money in a rising interest rate environment. So having exposure to financials is also a good idea.”

Pépin suggests this is as good a time as ever to think about the difference between strategic and tactical asset allocation, and offers some insight into how the latter can be employed in light of the recent inflation data.

“An investor should always start with a strategic benchmark. What it will look like will depend on his or her profile—age, risk tolerance, investment goals and other factors,” he notes.

But the economic climate isn’t static, so neither should the percentage weight initially given to the various asset classes.

“Usually tactical portfolio managers will stay away as much as possible from market timing, but try to anticipate things from a broader viewpoint. So they’ll say, ‘This is what we see developing six, nine months down the road, and we’ll gear the portfolio towards where we think things are heading.’ “

Pépin notes there are limits to how far these percentage weight shifts will deviate from the strategic benchmark, and how abruptly they can be made.

“In our tactical portfolios you always have to have at least 30% equities and 30% fixed income, but you can go up to 70% for either. But I don’t want to wake up one morning and find out my manager has gone from 40% to 70% equities all in one shot, because that shift will have too much of an impact on unitholders. It may trigger adverse tax consequences, for example.”

With inflation rising, and interest rates almost certainly to follow, the fixed income component of the portfolio requires close attention, Pépin suggests.

“Higher interest rates and higher inflation are usually the enemies of bonds, but there’s more to bonds than just government bonds. Higher interest rates and higher inflation are usually good for high yield bonds, because it’s usually a sign that the economy and corporate balance sheets are getting better. So typically the high yield bond market will react very similarly to the equity market—there’s a high correlation between the two.”

Pépin also suggests shortening the duration of government bonds, and “taking advantage of yield curves. Every type of bond—federal, provincial, municipal and corporate—will have a yield curve, and you want to be able to jump from one to the next within your policy.”

“So you don’t have to escape fixed income, but you need to look at what you have in your fixed income portfolio and adjust accordingly,” Pépin said.