A Wall Street chief strategist shares the best defense against a much-feared spike in inflation — and explains why it's a better option than 7 more traditional hedges

  • Jim Paulsen of The Leuthold Group says many traditional inflation-hedging strategies look ineffective or unappealing, and cyclical stocks might do a better job.
  • He writes that cyclicals have a strong track record during periods investors expect more inflation.
  • Experts have been warning about the possibility of a spike in inflation as a result of the Federal Reserve's stimulus packages and policy changes. 
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Some day inflation is going to go up, probably. It might seem like a remote possibility, but it's one that professionals think investors need to prepare for today.

The key is that the Federal Reserve is open to letting inflation "run hot" above its long-time target of 2%. However long it takes for the economy to recover from the coronavirus pandemic and adjust to new circumstances, that creates the possibility that it's going to breach that 2% level in a way that has rarely happened since the Great Recession.

Jim Paulsen, chief investment strategist for Leuthold Group, is just the latest to tell his public that it's time to reposition for that reality. 

"Given the unprecedented policy stimulus employed this year and the Federal Reserve's recent unconventional pledge to "let things run hot," it seems a good bet that the inflation expectation will return to old highs — if not beyond," he wrote in a note to clients.

The question is what to do. Since inflation has historically been a threat that worries a lot of investors, there are a lot of ways to react to it. The problem, to Paulsen, is that none of those hedges looks very appealing in the 2020s. 

"Cash and Treasury Inflation-Protected Securities may keep pace with inflation but offer little more because yields are so low," he wrote. That's not likely to change any time soon since the Fed has suggested that interest rates will stay near zero until 2023.

Commercial real estate, meanwhile, is also being hit hard by the pandemic and the rise of the work from home economy.

What about gold? Prices have soared 25% this year and topped a record $2,000 an ounce in early August. Oil prices are sensitive to inflation, but the pandemic crushed demand, supplies are increasing, and increasing worries about the climate are going to affect the energy industry and its stock prices.

"Other commodities, including timber and land, offer defensive inflationary properties but involve the unique ownership complications of illiquidity, managing futures/options cost of carry, or storage expense," Paulsen added.

Having run down all of those alternatives, Paulsen said there's another option that could help investors protect against inflation while bringing more to their portfolios than just a hedge.

"In the coming years, cyclical stocks could meet a broader range of investment goals — beyond inflation protection—including adding "cheaper stocks," diversification away from the high-flying (over-extended?) new-era stocks, and increasing the sensitivity of the portfolio to improved economic growth," he said.

Paulsen says that works because cyclicals — industrial, financial, consumer discretionary, and materials stocks — tend to outperform as inflation expectations rise. He says that held true from 2003-9 and also pulled it off from 2010 to the present.

He backs it up with this chart. It compares the performance equal-weighted cyclical sectors to the equal-weighted S&P 500, illustrating the performance of the stocks he's discussing, against the inflation expectations embedded in 10-year Treasury Inflation-Protected Securities.

"Cyclical stocks have outpaced the stock market by about +4.8% for every 1% increase in inflation expectations," Paulsen said. "This would likely make cyclicals the "darlings" of the stock market."

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