Perhaps retiring the word "transitory" when it is used with inflation would be smart, as per Fed Chairman Jerome Powell's comment in November 2021. But no matter if it's transitory or not, inflation will continue to affect retirement portfolios for now, according to Emilie Paquet, head of financial engineering at Manulife Investment Management, and Alex Grassino, Manulife's head of macro strategy, in a recent paper.
According to the duo inflation "is a new reality we can no longer ignore," and investors need to understand how it will affect their retirement portfolios.
Here are four points they highlighted in the paper:
1. Inflation will settle, but at slightly higher levels.
Could this rampant new inflation be a "new normal"? No, the team writes, noting that current inflation rates will be more "the exception than the rule: We expect that as supply chain bottlenecks improve, CPI growth will moderate" toward 2% by the end of 2022.
But due to "structural shifts" that happened during the pandemic, inflation likely will remain higher than what was seen in the decade after the 2007-2009 global financial crisis.
Three main factors will drive higher inflation: deglobalization, higher pressure on wages and higher oil prices. The result, they say, is "we expect inflation will ultimately settle somewhere slightly above 2%."
2. Higher inflation doesn't necessarily mean higher asset class returns.
Higher inflation probably won't be offset by higher returns, they note, largely due to "the murky relationship between CPI and different asset classes," and investing in riskier assets won't be enough to "compensate for the increase in inflation."
Key to this is a "moderate correlation between inflation and bond yield," which the duo says has been about 0.48 over the past 40 years. But that breaks down as investors head into risky assets such as stocks, they write. The correlation of the CPI with broad U.S. equities is -0.14, U.S. growth stocks 0.17 and U.S. value stocks 0.25, they note. For commodities it is 0.30.
Paquet and Grassino see portfolio diversification as the key to long-term success, "but we don't necessarily believe that asset allocation should be used as a stand-alone tool to compensate for higher inflation."
3. Even small increases in inflation can make a large impact on retirement portfolios.
So how to mitigate the effects of inflation on a retirement portfolio? In a word problem, they asked: "If I'm X years old and plan to retire at age 65, and expected inflation increases by Y%, how much more must I invest today to receive a predetermined amount of real (i.e., inflation adjusted) income drawn from my retirement portfolio?"
