Inflation is Looming… Where Can Investors Hide?

With the inflation genie starting to make its way out of the bottle, it is time for investors to refresh themselves on which asset classes provide the most protection to rising prices. The recent June 2021 numbers out from the U.S. showed the consumer price index (CPI) climbing 5.4% year-over-year which was its largest gain in 13 years. Canada’s recently released May inflation numbers showed a slightly lower 3.6% increase over the past year which was still the largest increase seen in 10 years.

While central bankers such as Jerome Power, US Federal Reserve Chairman, are quick to say these figures are “transitory”, there may be more price hikes coming through the production chain on their way to the end consumer. The more forward-looking producer prices index showed an even higher 7.3% increase over the past year to June.

With that being said, let’s take a look at which asset classes protect investors best (and leave investors most exposed!) to rising inflation.

Which Assets Provide Protection Against Inflation?

Treasury Inflation-Protected Securities (TIPS)

TIPS are a type of fixed income security where the principal face value is adjusted based on changes in the consumer price index. This is not to be confused with a variable rate bond, which adjusts the interest rate being paid but leaves the principal amount of the security exposed to the risks of inflation. Since the principal amount of the bond is the more significant part of the valuation, TIPS can provide better protection against inflation than variable-rate bonds. Like regular Treasury bonds, TIPS are backed by the government.

However, there are some limits to the inflation protection of TIPS. Since they are perceived as safer than regular Treasury bonds due to their lower inflation risk, investors are compensated less in terms of yield on a risk-return basis. Furthermore, the yield seen on regular bonds already implicitly prices in the expected inflation rate as well as the credit risk of the borrower. Under efficient market theory, this means that TIPS will only outperform if inflation turns out to be higher than market expectations.

Gold, Precious Metals, and Commodities

Gold is the classic hedge against inflation but other commodities can provide protection as well. While gold’s track record remains intact over the long-term (talking centuries), the asset’s correlation to inflation in the short-term is a little more questionable. With a correlation of only 0.16x to changes in the CPI over the past 50 years, gold might not look like that good of an inflation hedge. Some of the differences between the short and long-term inflation protection could be due to the price of gold moving speculatively ahead of anticipated changes in inflation, the benign levels of inflation seen during the past 50 years, as well as other supply and demand factors.

Commodities and other precious metals can also act as a good short-term hedge against inflation as well. After all, these are the raw material inputs into many of the products whose prices are increasing to begin with. However, over the long term, highly abundant commodities might actually see their price decrease in inflation-adjusted terms due to new technology making the extraction of the commodity more efficient and cheaper.

Real Estate

The ability to raise prices for tenants depends on the turnover of rental units and possibly also government regulations that directly link annual rent increases to inflation. This means that REITs are good for dealing with inflation due to the ability to raise rents. Rent increases also reflect favorably on the fair value of the property as well. On the downside, however, too high inflation can lead to higher interest rates on mortgages which will have a negative effect on heavily leveraged real estate companies. The higher interest rate paid on the debt will eat into, and possibly more than offset, the higher rents.  

Stocks for the Long-Term

In general, stocks perform well in an inflationary environment due to a company’s ability to raise prices to consumers and pass along the inflation seen in their input costs. The higher the brand power of the company (think Coca-Cola), the faster the company will be able to raise prices to consumers as well as push back against suppliers raising their input costs. This type of brand power can be seen in the stability of a company’s gross margin over business cycles. Weaker competitors in the industry may see their margins squeezed in the short-term as they have to stomach price increases from suppliers before being able to pass inflation along to the end consumer.

Which Assets Will Likely Suffer?

Technology and Growth Stocks Deflating

Higher inflation generally means that the risk-free rate, which is one of the main building blocks of the discount rate used to present value cash flows, is also higher. This means that cash flows in the future are worth less in the total valuation which can lead to significant changes for growth company valuations. Technology stocks are normally the asset to trade at higher growth rates but other assets could be vulnerable as well. The long-term ability of companies to raise prices discussed earlier is still present but the stocks in these sectors will benefit less due to the increase in discount rates used in valuations. 

Fixed Income

Higher inflation means higher bond interest rates. This reduces the relative worth of fixed income cash streams as newly issued bonds would have more attractive rates. As such, older fixed-income issues will normally trade at a discount to par value and historical investors are likely out of the money. While variable-rate bonds will adjust the interest rate paid on the principal, they will not adjust the principal of the loan itself. This would require a more TIPS style instrument discussed earlier which adjusts the principal for inflation.

While fixed-income investments are bad for investors, inflationary environments are a great time to be a borrower because of the decrease in the debt burden due to rising revenues as well as the economic increase in the value of long-term assets (which hopefully the borrowing is being used to finance).

Takeaway for Investors

Inflation can have a negative impact on an investment portfolio but if investors are diversified and tweak their most exposed areas in advance, the harm might be reduced. There are many assets that protect against inflation over the long term, investors just need to know where to look.

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