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Inflation is back (for now): Here's how to optimize your portfolio for rising prices

"If we're headed for a secular high-inflation regime, both stocks and bonds are likely to perform poorly."

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Inflation is back — at least for now. After years of hovering at around 2% or lower, the rate of rising prices has bounced in recent months, to 3.8% in May and 4.5% in June. With the latest inflation numbers, as measured by the Consumer Price Index, scheduled to publish Wednesday, investors are bracing for another round of eye-popping increases.

Higher-ups at the Federal Reserve continue to preach patience, insisting that the current drivers of inflation, such as post-lockdown supply-chain bottlenecks, are "transitory." For the most part, investors are buying it, and they continue to push markets higher.

"Investors are coming to terms with the reality that we're going have some inflation for three or four more quarters," says Yung-Yu Ma, chief investment strategist at BMO Wealth Management. "For now, they're willing to look past what the Fed says are largely temporary increases in inflation."

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Still, stock prices tend to move on big inflation news because prolonged periods of high inflation are bad news for investors. For one, rising prices erode the value of your savings, should you ever have to put them to use. And even if you're not withdrawing the money anytime soon, your portfolio may be ho-hum in the meantime. "If we're headed for a secular high-inflation regime, both stocks and bonds are likely to perform poorly," says Chun Wang, senior research analyst at the Leuthold Group.

What's a concerned investor to do? Nothing rash, experts say. Still, if you think inflation may be here to stay, making some tweaks around the margins of your portfolio could give you peace of mind while optimizing your holdings for rising prices.

Don't panic over rising prices

Even if tomorrow's inflation numbers come in much higher than expected, investors shouldn't begin considering it a long-term problem, says Ma. "If we get into May and June of next year and rental prices and wage inflation have not come down, that may be a sign that it's an ongoing, broad-based trend," he says. "It would be a clear sign to re-evaluate inflation concerns."

Although it may seem like a long time to wait, resist the urge to put a large chunk of your portfolio in an asset class that's typically used to fight inflation, says Sam Huszczo, a certified financial planner and founder of SGH Wealth Management in Southfield, Michigan.

"The easy answer has historically been gold, but over the short term, it's hard to predict what direction it's headed in," he says. The yellow stuff is down about 15% over the past 12 months, and its historical record as a hedge against inflation is spotty.

A big move into Treasury Inflation-Protected Securities, government bonds that pay higher interest rates as inflation rises, isn't going likely to give you much comfort in the long term, either. While TIPS can help protect a bond-heavy portfolio against inflation, stock investors are unlikely to be impressed with the returns. The yield on 5-year TIPS was recently -1.7%, meaning that if inflation were to hover around 3% annually, you'd earn 3% minus 1.7%, for an annual return of 1.3%.

"In this moment, there's no silver bullet out there for inflation," says Huszczo.

Adjust your stock holdings to hedge against inflation

If you think inflation is here to stay, consider optimizing your portfolio for rising prices. That doesn't mean making wholesale changes to your core investments. Rather, consider using sector ETFs to beef up your investments in companies and industries that can potentially benefit from inflation, and paring back your exposure to firms that will be hurt the most.

Favor industries that can easily pass on rising costs to consumers, especially businesses that sell a product that consumers have no choice but to buy. Energy firms are a good example: "You have to put gas in your car no matter what," Huszczo says. "We're forced to do that." Industrial and materials firms are other potential inflation beneficiaries for the same reasons.

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Some real estate stocks would likely perform well too, if firms are able to hike rent alongside rising prices, says Ma. "Multifamily housing and manufactured-homes firms have done well and would continue to do well.".

On the other side of the equation, industries that can't raise prices will have trouble maintaining profits if inflation persists, says Wang. "Companies in industries where pricing power is poor, or that are getting eroded by competition or disruption are in the worst position," he says. "It will be difficult for them to maintain a margin squeeze." He points to pharmaceutical, health-care, and entertainment firms as potential examples.

Making small changes to your portfolio may help protect your returns from inflation, but for long-term investors, doing nothing isn't a bad idea, either, says Ma. "The trends that have kept a lid on inflation for years have taken a back seat, but we expect them to reassert themselves," he says. "We think that's the case if you look beyond 12 months from now."

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