Portfolio positioning in an inflationary environment

Although elevated inflation rates may not last, they may have your retired clients — or clients nearing retirement — worried about losing purchasing power.

In May, the annual rate of inflation hit 3.6% after reaching 3.4% in April. The spike came as no surprise; prices plummeted at the onset of the pandemic and were expected to increase as the economy reopened and pent-up demand was unleashed.

The rapid increase in inflation is likely transitory. The Bank of Canada predicts inflation will hover around 3% over the summer before cooling down again — but that may be of little comfort to clients who are worried about the prices they’re seeing now.

“I have clients who are retired or are entering retirement who have a reduction of equities in their portfolio and lean more toward fixed income for safety,” said Robyn Thompson, president of Castlemark Wealth Management Inc. in Toronto. “They have significantly higher concerns about inflation than clients who have a long duration until they retire.”

Those concerns are only exacerbated by rock-bottom interest rates that have resulted in fixed-income securities and GICs that don’t come close to keeping up with inflation, Thompson said.

Given the paltry payouts from fixed income, retired clients may want to generate income through dividend-paying stocks and REITs. Thompson said she’s been repositioning clients’ portfolios to increase their exposure to sectors that benefit from inflationary environments.

“At the moment I like financials, which is an area that does well in rising-rate inflationary cycles as banks borrow at the short end of the curve and lend at the long end,” she said.

And banks may soon be increasing their dividends. At the onset of the pandemic, the Office of the Superintendent for Financial Institutions ordered banks to halt dividend increases and share buybacks — a condition that will eventually be lifted as the economy continues its recovery.

“Once the restrictions are lifted, I’d suspect you’re going to see dividend hikes from the banks as they start to normalize,” Thompson said.

Thompson said it’s important to avoid wholesale changes to portfolios in response to the current spike in inflation. She reminds clients that their portfolio construction assumes an annual inflation rate of 2%, and the recent jump in prices is likely a blip.

For clients who still have a bit of runway to their golden years, Thompson has been shifting portfolios out of growth stocks and into value names.

“Instead of overweighting to consumer staples, utilities and technology, which are typically prescribed for low-rate environments, they can consider things that are more cyclically orientated, like materials, industrials and consumer discretionary,” she said.

Whether elevated inflation rates are truly a short-term phenomenon or part of a longer trend remains to be seen, but Thompson said most of her clients weren’t taken aback by the price hikes they’ve witnessed this summer.

“For the most part, clients do understand that as the world comes back online and we start to see an increase in pent-up demand, you’re going to see some inflationary pressures. But I do think that clients are aware that it’s a short-term event.”