Written by Andrew Cassar Overend
14 min read
Last Updated on June 29, 2021
With inflation looming ahead, it is important to ensure you own assets which appreciate in price at a rate that beats inflation. While it has yet to be seen whether inflation will be permanent or not, it would be wise to understand how to inflation-proof your portfolio so that your investment returns will never fall victim to this silent wealth destructor.
You can also find a visual summary of the article by clicking here.
Recall that in our interest rates master class, we distinguished between nominal and real interest rates. The nominal interest rate is the interest rate we officially pay on the amounts we borrow and the one we get paid on our bank deposits. When we subtract inflation from the nominal interest rate, we obtain the real interest rate. Therefore, a higher rate of inflation reduces the real interest rate.
Say you want to save enough money so that eventually you can retire comfortably. But in the present market environment, with bank deposit rates at 0%, our cash savings cannot compound. And remember that silent-wealth destructor called inflation? If inflation is positive and with our deposits earning 0%, cash becomes a negative yielding asset (because 0% minus a positive inflation number gives a negative return).
This means that the cash savings you have right now will have less purchasing power in the future because it is being obliterated by inflation. Even if you deposit your cash into a fixed-term savings account which yields an annual return less than the rate of inflation, you will be losing purchasing power.
Most fixed-rate savings accounts do not yield more than 1%. If you deposit $1000 and inflation is 4%, then the purchasing power of the money in the savings account the following year falls by 3% (1% - 4% = -3%). Although the nominal value of your savings will be $1010, inflation would shave off $40 (4% x $1000), meaning that the purchasing power of your savings will be $970.
The following chart shows the purchasing power of the dollar since 1960 mapped against real disposable income.
The interest rate is the price of money. It is the compensation required for lenders to lend, and the magnitude of the interest rates reflects the market's best bet on the future worth of the currency.
When buying bonds, you are lending money to the borrower (Government or corporation) in return for a series of fixed repayments until the bond matures. Because the repayment is fixed, in the presence of inflation, the fixed future repayments lose substantial value.
In sum, if the rate of inflation exceeds the nominal yield of a bond, then the real yield falls. Therefore, when the probability of inflation is high, bonds are the least attractive asset to hold.
This chart shows a historical comparison of real yields on bonds of key jurisdictions:
If the yield on the bond is positive, then irrespective of inflation, holding bonds will provide you with a better yield than holding your money in cash. This is because cash is a zero yielding asset, so in the presence of inflation, the purchasing ability of your cash is negative. But in the case of negative yielding bonds, then it makes more sense to hold money in cash than in bonds.
In March 2021, the average yield on the 10 year US bond was 1.64%. The average rate of inflation was 4.2%, meaning that the real yield on the bond was -2.5%. The yield on bank savings was 0%, meaning that the real purchasing power of the same money since March 2020 fell by 4.2%. In this case, a negative 2.5% yield is 'better' than a negative 4.2% loss of purchasing power.
On the other hand, for those lending to the German government over a 10 year maturity, the yield in March 2021 was -0.36%. Inflation in Germany increased by 1.7%, meaning that the real yield on German bonds was -2.1%. However, had the lender held the money in cash rather than lending it out to the German government, the purchasing power of the cash would have fallen by the rate of inflation: 1.7%. This means that when bonds have negative yields, in the presence of inflation it makes sense to hold cash.
In practice, the openness of capital markets allows investors to invest overseas. So German investors could have parked their money in the US rather than lend to their own government and lose money. However, negative yielding bonds may sometimes be attractive for foreign investors who anticipate that an appreciation in the foreign currency relative to their domestic currency will compensate them for holding the negative yielding bond.
In the presence of deflation (i.e. negative inflation) bonds which provide lenders with a positive nominal yield do well. The purchasing power of cash also increases. Those bonds which provide negative nominal yields will also provide a more favourable real yield for the lender. This means that while bonds are unattractive during inflation, they do well in a disinflationary or deflationary environment.
When assessing the performance of equities in the presence of inflation we observe that the overall market returns sometimes failed to beat inflation. For the US, this was particularly the case in the 1974 recession, and even towards the end of the 1970s.
But equities may also provide some protection against inflation. Why? Although we consumers do not welcome inflation, because we end up paying more for the same value, who does well when prices go up? Those businesses which increase their prices of course!
In fact, the nominal value (monetary value) of a company's sales increases because of inflation.
For example, last year ABC Ltd sold 10,000 shoes at $10 each. The total revenue made was equal to $100,000. This year, higher leather prices used to make shoes caused ABC Ltd to increase their price to $13 per shoe. Due to the higher price, ABC Ltd only sold 8500 shoes this year. Despite the drop in volume, total revenue was $110,500, which is higher than last years' revenue.
But not all equities perform well in the presence of inflation. The performance of equities under inflation depends on the type of company you hold. Equity performance depends on:
whether the company is well established or still growing at a rapid pace - growth stocks
the extent to which the higher input costs can be passed on to consumers - as long as a company's revenue growth outpaces any increases in costs of production, then earnings should not be badly affected.
the sector the company operates in - this follows from the previous point. Companies in certain sectors are able to withstand inflation because they provide an inelastic good or service.
This helpful scatter chart by Hartford Funds shows the performance of various sectors during a rising inflation environment.
The performance of energy companies highly correlates with the price of energy commodities like oil and gas. Given the widespread use of these commodities, these companies push the higher energy costs onto the consumer who has no choice but to pay the higher prices.
The nature of the Consumer Staples sector is implied in its name: inelasticgoods and services such as food, toiletries and other essentials need to be bought irrespective of any price rises. The Health sector is another sector with inelastic end-product, but you need to filter out those health stocks which actually manufacture or sell medically approved products. This is because an increasing number of health stocks are delving into biotech, genomics and other ambitious areas which require heavy capital investment which may weigh on earnings or exacerbate losses in an inflationary environment.
The worst performing sectors are Consumer Discretionary sector, the IT sector and the Mortgage REITs sector. Since Consumer Discretionary goods and services are non-essential, higher prices in this sector can lead to lower demand, which in turn means lower earnings growth. The IT sector mainly comprises growth stocks, meaning that the present value of future cash flows is suppressed in the presence of inflation. Mortgage REITs are like bonds, in the sense that they distribute a fixed periodic payment to the investor. This means that if inflation emerges, the fixed future payments will have lower purchasing power, so investor appetite for equities in the sector declines.
But how will you know how likely the company is able to pass on prices to consumers? We will never know for sure, but some common sense can help us figure things out.
|Oil||XLE, BP, Shell||Commodity|
|Pharmaceuticals||Johnson and Johnson, Merck||Essentials|
|Banks||JP Morgan, Citigroup||Benefit from higher interest rate|
|Daily Needs (Food, Toiletries)||Amazon, Walmart, Target||Essentials|
|Software||Adobe, Microsoft||Branding Power|
|Internet & Social Media||Google, Facebook||Large intangible assets like databases|
|Payment Processing||PayPal, Visa||Benefit from higher fees|
In sum, the stocks which are likely to perform the best are those which have a brand monopoly that allows them to pass on production costs to consumers and also those companies which supply consumer needs. Commodity stocks also do well, so companies which are involved in the mining of metals and infrastructure projects will benefit. Moreover, those companies which have significant intangible assets
Contrary to the intangible assets mentioned in the previous sections, real estate is a physical asset. There are several categories of real estate, including residential, industrial and commercial.
If you own any of these types of real estate and you rent them out, you will benefit from both periodic income as well as property price appreciation.
Studies show that rental income increases do a good job of keeping up with inflation, with residential performing the best and commercial doing the worst. The reason for higher rental prices is that when house prices go up because of inflation, people are discouraged from buying new homes and choose to rent instead. A higher demand for rental property allows real estate investors to escalate their rental prices.
That said, the costs of renting out real estate may also increase because of inflation in goods and maintenance. But as long as you pass on these higher operating costs to the tenant, such as by increasing rental prices in line with the CPI, real estate should maintain its value in an inflationary environment.
But real estate investors also benefit from an overall increase in the value of the property, again with residential properties outperforming commercial and industrial properties.
The following chart shows real residential property price changes in the US since the 1970s. During non-recessionary inflationary periods, real estate does a great job in hedging against inflation. Throughout the late 1970s when inflation started to re-escalate in the US, house prices increased at a faster rate than inflation, but eventually crashed throughout the 1980s recession.
And this graph shows house and rental prices in Japan:
If you do not hold physical real estate, you can still hold a financial instrument which tracks real estate prices. The asset class is called Real Estate Investment Trusts (REITs). REITs own a variety of physical properties. As shown in the scatter plot in the previous section, REITs provide a great inflation hedge.
Since it was first excavated thousands of years ago, gold has always been valuable to mankind, both because of its beauty and its scarcity. Silver shares the same properties as gold although it is not as scarce, but is also widely used in industrial production.
Historically, gold was used to mint currencies, but over time currencies started to be created with less and less gold and currencies were devalued.
Many gold-bugs suggest that gold is the optimal hedge against inflation. However, if we observe the chart of gold against inflation, the relationship seems quite weak.
Besides, on a cumulative basis, gold actually lost value from the 1970s to the early years of the millennium. So why is gold perceived to be a good hedge against inflation?
Firstly, gold is a commodity and we already noted that commodities do well in an inflationary environment.
Secondly, gold receives more demand when:
There is monetary inflation. Recall from our inflation master class that money creation by the Central Bank need not necessarily translate into goods and services inflation. Instead, it can boost the prices of assets like gold and stocks.
The real yield on safe assets falls. Recall that real yield is the nominal yield minus expected inflation. As discussed in the bond section above, when inflation outweighs the pace of increases in nominal yields on bonds, then real yields on bonds fall, and gold becomes a more attractive asset to hold.
The dollar declines. Because gold is priced in dollars, when the denominator falls, then gold prices increase.
There is a crisis. Although inflation is not a crisis in itself, the graphs presented in this piece show that severe inflationary episodes occurred immediately prior to an economic crisis, when real growth falls and prices fall.
The following chart shows the inverse relationship between gold prices and the real interest rate:
Therefore, from the above analysis it seems prudent to conclude that the weight which gold should have in our investment portfolios depends on the type of inflation being encountered.
If the inflation is purely because Central Banks are creating more money which causes a deterioration in the purchasing power of the currency, then precious metals will be a good store of value. But if inflation causes economic overheating which will force interest rates to sharply escalate and cause the real yield to increase, then precious metals may not be the inflation hedge it is famous for. However, when economic growth slows and real yields decrease, then precious metals become attractive as a hedge against a potential crisis.
While some stocks may protect you against inflation, a fundamental problem remains: stocks are denominated in fiat currency. And in the presence of monetary inflation, fiat currency loses value. In our article on the value of savings we explored how a devaluation occurs.
The advent of blockchain technology has enabled the creation of Bitcoin, other cryptocurrencies referred to as altcoins and a variety of other digital products like non-fungible tokens (NFTs) .
Although cryptocurrencies have yet to be formally categorized by regulators as a currency or an asset, their value lies in the fact that they are independent from government manipulation, making them immune to any devaluation.
Since Bitcoin has only been in existence since 2008, it has insufficient history test its performance under inflation. But since by definition inflation is a loss in purchasing power of the currency, then everything else denominated in that currency increases in value.
In fact, the surge in Bitcoin following the pandemic can be attributed to three key reasons:
People realizing that the financial system is broken
Because money printing by global Central Banks is devaluing currencies which may also cause goods and services prices to rise
Because of institutional adoption
With these factors in mind, the narrative for holding Bitcoin as a hedge against currency devaluation means that it should do well in an inflationary environment, especially if Central Banks continue to expand their balance sheets.
Altcoin price movements generally correlate to the price of Bitcoin. I consider them to be bets on the future rather than a direct hedge against inflation. That said, if developers continue to improve their use cases at such an impressive rate, their price gains will surely beat inflation.
Finally, rare assets such as art, fine wine, watches, and collectibles in both physical form (like baseball cards) or digital form (NFTs) can also retain their value against inflation.
We understand that it is inevitable to keep some cash in hand. Does this mean that this cash will lose value? Not necessarily. This depends on how high inflation is, but you can always partially offset the negative effects using by converting this cash into:
Exchange Traded Funds which track inflation such as INFL
If you are close to retirement and you don't want to take on significant risk then the above may be viable choices. If you are a younger investor who is less risk averse but are nonetheless concerned with the value of your cash savings, you can also consider more aggressive approaches like selling covered calls or non-naked puts using options to earn monthly yield, or converting some of your fiat currency holdings into stable coins and staking your coins to earn interest. However do note that these are risky strategies which you should not succumb your entire cash savings to.
We are already experiencing inflation. The question is whether this inflation will be sustained. If you indeed think that inflation is here to stay, then you'd better ensure that your portfolio is inflation proof.
However, that is only part of the story. How will Central Banks react to rising inflation? Will an announcement to increase interest rates result in an economic slowdown? How will the markets respond? If you are uncertain on what policy options lie ahead, you can explore some scenarios here.
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