Inflation was already a pressing issue for the economy before Russia went to war with Ukraine. Now, the problem has broken wide open. With the entire commodity chain skyrocketing on potential supply chain disruptions and gold topping $2000/oz for the first time since the Great Financial Crisis of 2008, TDR explored the best inflation hedges to protect (and grow) capital during these trying times.
Many investors tend to downplay the impact of inflation because it tends to fluctuate and be transitory in nature. However, sometimes it can remain persistent for a prolonged periods of time, causing volatility in most asset markets. With the U.S. Consumer Price Index (CPI) organically reaching 40-year highs in January, the situation has degraded further after Russia’ invasion with Ukraine while central banks are looking to raise interest rates. The double whammy is hitting asset prices across all domains quite hard.
The problem for the market is uncertainty about how high rates need to go to effectively tame inflation down to normal levels. One of the primary causes for this iteration of inflation are supply chain breakdowns as opposed to overheating economic activity, so raising rates will have a more limited effect. This is otherwise known as “cost-push” inflation, which occurs when overall prices increase due to increases in the cost of wages and raw materials—not from overheating demand.
The good news is that we’ve been here before, so we know what inflation hedge strategies have worked in the past. It is with this focus that we recap some time-tested strategies for dealing with investing in a high inflation environment.
5. Treasury Inflation Protected Securities (TIPS)
TIPS are issued and backed by the U.S. government like typical Treasury bonds, however, these securities come with protection against inflation. The principal portion of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. So inflation rises, the value of the principal will rise as well to maintain its value.
So if you believe the government’s version of measuring inflation and not the “shadow” number, which is generally higher than the BLS number, TIPS is a viable capital protection hedge. But you won’t want to own it in normal inflationary times, because there is potential for capital appreciation is minimal compared to growth sectors.
4. Commodity ETFs
Commodities are a broad category that include everything from grain and beef to precious metals. Commodities offer a unique protection against inflation and are effective against both demand-push and cost-push inflation. As the price of a commodity rises, so does the price of the products that the commodity is used to produce.
Gold is the most renowned of the commodity inflation hedges but others can do well pending circumstances. For example, Wheat futures has recently extended a relentless surge towards all-time highs amid fears of a global commodity shock as Russia’s invasion of Ukraine shuts off a crucial source of exports and threatens future production. The record close for a most actively traded contract was set on March 12, 2008, while an all-time intraday high of $13.50 was set on Feb. 27, 2008.
While a rising tide lifts all boats, performance in commodity subtypes will vary based on particular demand or sopply throttle profile. So if you do your homework, the right commodity inflation hedges are always available.
Investors buy utility stocks primarily to earn an attractive dividend yield. As inflation rises, interest rates on other yield-focused investments will rise, which increases the yield further. Although the underlying stock price could fall inline with other market assets, demand for utilities is fairly inelastic, which means consumers generally can’t do without these products & services. As a result, demand stays fairly constant in recessionary environment brought about by high inflation.
The upshot is that utility stock investors will continue to earn the high dividends that attracted them to these investments in the first place, although the equity may decline in value. But utility stocks generally don’t fall as hard as growth or consumer discretionary stock can, for example.
2. Real Estate
Real estate can be a solid asset in high inflation environments for many reasons. Chief among them are consumers that seek to purchase real assets that tend to increase steadily in value over time. This can lead to higher rent payments from tenants and lower loan-to-value ratios on mortgage debt. Specifically property sectors with short-term lease structures like multi-family properties, because higher home prices often equal higher rent.
Be careful of the negative effect recessionary impulses can have after periods of higher inflation. Real estate prices can fall during these periods as weakness in the broad economy can effect affordability with consumers. But in the normal and inflationary stages of the business cycle, real estate is generally a good option.
1. Precious Metals (Physical and ETFs)
Although there is a lot of evidence that gold is an imperfect hedge against inflation, it’s still one of best assets to hold in times of duress. Gold has a tendency to go through prolonged periods of sideways or moribund price action, before the “hedge” aspect to inflation kicks in. In other words, while U.S. CPI is registering its customary 2-3% gain annually and the stock market is humming along, gold isn’t much of a hedge against anything (dead asset). But when inflation is soaring—such as in 1980, to a lesser degree in 2008 and today—gold tends to play catch-up and make up for lost time, providing inflation protection to individual portfolios as well as capital gains.
Holding the physical metal is also a good option and maintains the security of holding the actual asset instead of (potentially) re-hypothecated paper. If you can stomach the liquidity issues of resale and extra costs of storage, maintaining a percentage in physical bullion may be a good option.