Inflation Is Here to Stay. Here’s How to Adjust Your Portfolio.

Bonds have logged losses this year along with stocks, a disconcerting development for those who long considered their fixed-income holdings “safe” assets. With the Federal Reserve expected to fight inflation by lifting its targeted federal-funds rate to more than 2% from a current range of 0.25% to 0.50%, the 40-year bond bull market could well be nearing an end.

Commodities, meanwhile, just had their best quarter in 30 years, rising 29%, as measured by the S&P GSCI benchmark. The gains stemmed from supply-and-demand dislocations created by the Covid pandemic, with supply chains further disrupted by the war in Ukraine and Western sanctions on Russia.

Many of the forces contributing to inflation won’t be unwound soon, even if the pandemic continues to ease and a truce is reached in Ukraine. Chief executives of companies such as Micron Technology (ticker: MU), Cisco Systems (CSCO), and Intel (INTC) have warned that shortages could persist into 2023, says Stephanie Link, chief investment strategist at Hightower Advisors.

Structural forces, too, could keep prices higher than they have been in years. Commodities producers, including energy companies, have underinvested in recent years, after a period of unbridled growth eroded shareholder returns. Likewise, a shift toward electrification, digitization, and even decarbonization adds to inflationary pressure.

Finally, housing and labor costs are rising. Wage pressure could increase further as countries move to become more self-reliant in strategic areas from technology and energy to defense and food. High housing and labor costs are particularly sticky.

“The markets are still underappreciating inflation risk over coming years,” says Rebecca Patterson, chief investment strategist at Bridgewater Associates, which oversees $150 billion. “It makes a lot of sense to have a more inflation-balanced portfolio than investors have had over the past four decades. It’s a new world.”

Balance is the key here, and much depends on an investor’s age, risk tolerance, and existing portfolio. For example, a young investor can stick primarily with stocks, whereas a retiree already drawing down a portfolio might want more direct inflation protection, including inflation-linked and shorter-duration bonds, commodities, and real estate investment trusts.

This isn’t a time to dump bonds altogether, however. Even if they provide less cushion than in the past, they remain an important source of diversification. It would take an average 10-year rolling inflation rate of 3.5% for bonds to lose their diversification capabilities, according to research from Vanguard. That’s not currently in the cards; core inflation would have to run at an annual rate of 5.7%—much higher than current expectations—over the next five years for inflation to average 3% in a 10-year period.

Even stock portfolios need rebalancing in a high-inflation environment. Many financial advisors and market strategists recommend taking some money out of the richly priced technology and megacap growth stocks that powered the market higher in recent years, and investing more in value-oriented and small-cap stocks. Smaller companies in the energy and banking sectors, for instance, tend to benefit from higher commodity prices and higher interest rates.

Yet, all sources of protection come with their own risks. “An environment dominated by inflation that is driven by supply will be more volatile,” says Jean Boivin, head of the BlackRock Investment Institute. “Central banks won’t be able to stabilize or contain it as effectively as they did over the past 40 years.”

A variety of mutual funds can help investors dull the impact of inflation—or benefit from it. Amy Arnott, a portfolio strategist at Morningstar, recommends investing in commodities, a notoriously volatile asset class, through diversified funds such as the $2.6 billion Pimco Inflation Response Multi-Asset (PZRMX) and the $5.6 billion DWS RREEF Real Assets (AAAAX). Commodities provided the most reliable inflation hedge during the inflationary period of the 1960s to 1970s, with gold and real estate doing well, but not in all inflationary periods, says Arnott.

The Pimco fund, which returned an average annual 7% over the past five years, to beat 97% of peers, tries to strike a balance among commodities; Treasury inflation-protected securities, or TIPS; gold; real estate investment trusts; and emerging market currencies. The fund makes direct investments in commodities, rather than the shares of commodity producers.

Co-manager Greg Sharenow sees continued opportunities in energy as demand for renewables and military spending grows. “These capital-spending systems are energy-intensive,” he says.

The DWS fund, which has returned an average of 11% a year over the past five years, to beat 98% of its peers, takes a balanced approach across real estate, infrastructure, natural resources, and commodities, tilting the portfolio toward areas that offer the best opportunities based on whether inflation is accelerating or decelerating. The fund’s allocation to commodities rose to as much as 40% last year from 15% two years prior.

Co-manager Evan Rudy has since whittled that back to 30%. He favors shares of commodity producers such as potash makers Nutrien (NTR) and Mosaic (MOS) over direct commodity investments, in part because the companies have strong balance sheets that allow them to buy back stock and pay dividends. Also attractive: infrastructure-oriented companies, like oil and gas transporters benefiting from energy constraints in Europe, and regulated energy utilities.

The iShares S&P GSCI Commodity-Indexed Trust (GSG) offers diversified commodities exposure. It invests in energy, industrial, precious-metals, agricultural, and livestock futures. However, Sierra Investment Management’s David Wright suggests using stop-loss orders with this and similar exchange-traded funds, given commodities’ volatility and their recent run-up.

Equity funds with a heavy helping of energy and financials offer another way to protect against the ravages of inflation while benefiting from higher prices. The $10.1 billion Invesco Comstock (ACSTX) returned 16% over the past year to beat 91% of peers. The deep-value fund has had roughly double the energy allocation of its peers, or about 12%. Co-manager Kevin Holt is now reducing that stake after recent gains, although he still sees structural reasons for oil prices to stay elevated.

Lately, Holt has been adding selectively to consumer staples, favoring companies whose free cash flow may be more sustainable than the market thinks. He is also looking for companies suffering from a rise in commodity prices. Some price spikes, such as that in pulp, might not be as long-lasting as the rise in oil prices, he says. As a result, users of pulp, such as toilet-tissue manufacturers, could see pressure on profit margins start to ease, creating an opportunity in their shares.

Also attractive: staples companies such as cigarette maker Altria Group (MO), which is less susceptible to the commodity spike than food companies and has more pricing power.

Financials account for roughly a quarter of Invesco Comstock’s assets. Holt favors regional banks, whose earnings should get a boost from improving loan growth and rising net interest margins as the Federal Reserve hikes interest rates. Regionals are less reliant than money-center banks on capital-markets businesses that could begin to slow after a strong run. Wells Fargo (WFC) is a top fund holding; Holt sees the bank turning around after several scandal-plagued years.

The $3.2 billion Fidelity Large Cap Stock (FLCSX), which returned 13% a year over the past five years, beating 88% of peers, is another core fund with a value bent that has a higher allocation than peers to inflation beneficiaries such as energy. “If you think oil prices will stay high, energy stocks aren’t expensive versus history,” says manager Matthew Fruhan.

Fruhan hunts for companies whose expected earnings over the next three years have been mispriced by the market. Commercial aerospace companies are a case in point, as he expects a recovery in corporate and leisure travel to improve the industry’s prospects, even if demand doesn’t reset back to pre-Covid levels. General Electric (GE) is a top fund holding.

While megacaps were favored in recent years, small-cap stocks have historically outperformed in times of rising commodity prices, according to Jill Hall, Bank of America head of U.S. small- and mid-cap strategy. Rising commodity prices usually spur increased capital spending, which Hall says has helped small-cap companies’ sales more than those of larger concerns.

Small-cap companies’ margins are also less negatively correlated with labor costs and CPI. One possible reason: The Russell 2000 index is tilted more toward beneficiaries of oil-price hikes, such as energy and capital-goods companies, than to consumer-oriented sectors that are more likely to get hit by higher oil prices and that have a heavier weighting in large-cap indexes. A quick way to get exposure is through the iShares Russell 2000 ETF (IWM).

With inflation raging and the Fed lifting rates, bonds pose the biggest challenge for investors. (Bond prices move inversely to yields.) “If inflation is the biggest fear, then almost any bond fund isn’t going to be a refuge,” says Eric Jacobson, fixed-income strategist at Morningstar. “That’s not what it’s for.”

Typically, bond portfolios offered ballast and were a source of income—although that status was challenged in an era of low interest rates. Floating-rate debt offers one way to get income today and benefit from rising rates. Such loans usually are made to below-investment-grade borrowers, which means they carry more risk. But coupons reset on a regular basis, allowing investors to benefit from rising rates.

This is a tactical strategy for the next six to 12 months, based on the view that the U.S. economy isn’t headed for a recession—yet, at least. The T. Rowe Price Floating Rate fund (PRFRX) has done comparatively well in various market backdrops, registering a better-than-peers loss of 20% during the worst part of the selloff in 2020 while also erasing those losses faster, according to Morningstar. Another option: the $10.2 billion SPDR Blackstone Senior Loan ETF (SRLN), whose 3.7% average return over the past five years beat 91% of peers. The fund focuses on the most liquid part of the bank-loan market.

Shorter-duration bonds are less sensitive to interest-rate hikes, and should hold up better than other bonds if the Fed raises rates beyond what the market is expecting, says Christopher Alwine, who oversees $250 billion in Vanguard’s actively managed taxable-bond strategies.

Morningstar’s Jacobsen recommends two core bond funds with shorter duration than peers: the $4.5 billion Fidelity Intermediate Bond (FTHRX), which limits below-investment-grade exposure to 10%, and the $68.7 billion Dodge & Cox Income (DODIX), which has a higher allocation to corporate and securitized debt than peers but also had 6% in cash and equivalents as of the last reporting period.

The Dodge & Cox fund returned an average of 3% over the past decade, beating almost 80% of its peers. The Fidelity fund’s 1.7% average annual return over the past five years put it in the middle of the pack, but Morningstar analysts say it tended to shine during past bouts of rate volatility, and it is beating 90% of peers so far this year, with a loss of under 5.5%.

TIPS are the go-to inflation hedge to preserve purchasing power. Vanguard allocates 25% of its bond bucket to TIPS in its retirement-income portfolios. Short-dated TIPS are pricing in a good deal of inflation, which may mean it is too late to add these, says GenTrust Chief Investment Officer Jim Besaw. But longer-term TIPS could offer better protection, especially if inflation stays elevated for longer than the market anticipates.

The $41.2 billion Vanguard Inflation-Protected Securities fund (VIPSX), with a duration of 7.5 years, longer than peers, is one way to gain exposure to TIPS. The $1.5 billion SPDR Bloomberg 1-10 Year TIPS ETF (TIPX) is another. It has a duration of about 4.8 years, a bit longer than most of the short-term funds on the market. One caveat: TIPS can come with some tax wrinkles, a reason to own them in a tax-deferred account.

Treasury Series I Saving Bonds, currently paying just a bit more than 7%, are another option. You can buy up to $10,000 of the bonds per year through the Treasury Department.

Investors also shouldn’t neglect cash, especially in light of the market’s recent volatility. Rates on certificates of deposit are inching higher, although they are still far below the rate of inflation. Besides, cash could come in handy in the event of another big market selloff.

Write to Reshma Kapadia at reshma.kapadia@barrons.com