Investing for Inflation

by | Aug 18, 2020 | Uncategorized | 0 comments

The US Federal Government’s massive $5.6 trillion expansionary policies through July 31, 2020 mitigated much of the short-term economic damage from the government-mandated shut-down, but is causing many investors to worry about impending inflation. The $5.6 trillion consists of $2.8 trillion of federal deficit spending and $2.8 trillion of increased household money supply by the Federal Reserve Bank (‘the Fed”).

Will Inflation Rise?

Inflation is the result of too many dollars chasing too few goods. While fears of spreading Covid-19 continue to depress consumer spending, inflation remains contained. Once pandemic-related restrictions end, pent-up demand for previously limited services (e.g., travel, restaurant dining, live sports, and retail shopping) combined with an additional $5.6 trillion dollars in the economy has the potential to quickly drive up prices. To put $5.6 trillion in context, America’s first quarter gross domestic product (GDP) was $21.6 trillion (annual rate).

The Fed expanded the money supply primarily by printing money, which they call “quantitative easing.” History is full of examples where printing money caused prices to spiral out of control, eroding the real value of savings, such as bank accounts and bond portfolios.

What to Own?

Investors often think of gold, Treasury-Inflation Protected Securities (TIPS), and real estate as safe havens from inflation. However, natural resources and companies with pricing power offer the best inflation protection. Short-term bonds can stay close to inflation by continually renewing at subsequently higher yields, but may not produce a positive real return.

Natural Resources

Natural resource stocks are comprised primarily of companies in the energy and materials sectors. They have historically protected against inflation and significantly increased purchasing power in most inflationary periods, according to an analysis by Lucas White and Jeremy Grantham of GMO in 2016, “An Investment Only a Mother Could Love: The Case for Natural Resource Equities”.

Exchange traded funds (ETF) with a combination of energy and materials holdings include:

  1. SPDR® S&P Global Natural Resources ETF (GNR), 3.73% SEC yield.
  2. VanEck Vectors Natural Resources ETF (HAP), 3.00% SEC yield.
  3. SPDR S&P® North American Natural Resources ETF (NANR), 2.80% SEC yield.

Alternatively, investors may prefer to buy separate ETFs that specialize in energy and materials sectors individually. Examples include the Energy Select Sector SPDR® ETF (XLE) with a 6.03% SEC yield and Materials Select Sector SPDR® ETF (XLB) with a 1.99% SEC yield.

Stocks in Other Sectors

Companies with pricing power offer excellent protection from inflation because their customers are willing to pay higher inflation-adjusted prices to obtain their goods or services. Businesses with pricing power include pharmaceutical (e.g., Merck, Novartis, Novo-Nordisk), consumer staples (e.g., Altria, Unilever, Colgate-Palmolive), and unique or monopoly offerings (e.g., Adobe, Facebook, Microsoft, Qualcomm).

Short-term Bonds

Short-term bonds enable investors to frequently obtain the latest interest rate as they roll-over maturing bonds into new issues. This is a reasonable approach, but may not produce a positive real return as investors stay one step behind rising interest rates.

TIPS

Treasury Inflation-Protected Securities, or TIPS, provide some protection against inflation, but they aren’t necessarily a good investment.

  1. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index (CPI). However, the CPI may under-report inflation because housing, food, and energy prices are excluded from the index. Those are major household expenses!
  2. TIPS may not perform better than regular Treasuries. TIPS are only likely to perform better than Treasury bonds if actual CPI is higher than what the market anticipates because investors require compensation for expected inflation in regular Treasuries. Since CPI is biased against inflation, market inflation expectations are often higher than the CPI. The result is a lower real interest rate for TIPS.
  3. If interest rates rise, prices of issued TIPS will fall on the secondary market. Interest rates and CPI don’t necessarily move together. As a result, investors who sell before maturity can lose principal.

Gold

Gold spiked 27% from $1,524.50 an ounce on January 2, 2020 to $1,939.80 on August 14 in response to concerns about inflation and a weak US dollar. Although gold is widely used as a safe haven during times of stress it doesn’t always offer the best protection against inflation.

Gold performed well during the high inflationary period of the 1970s, when surging oil prices and a rapidly expanding monetary supply drove inflation to historically high levels. During the more muted inflationary environments of the early 1980s and 1988-91, gold produced negative total returns, on average, and lagged large-cap stocks by a wide margin, according to Morningstar analysts.

Perhaps more important, gold does not produce earnings. Investments that produce earnings are more valuable than those that do not, making gold relatively unattractive. A better way to own gold may be to own profitable gold miners. Gold miners would likely be included in the materials category of funds that invest in natural resources.

Real Estate

Publicly-traded real estate investment trusts (REITs) show no reliable inflation sensitivities, according to a statistical analysis of publicly-traded REIT returns since 1972, which includes high inflation periods. The analysis was conducted by Northern Trust and published October 15, 2018 in an article titled “How Real are Real Assets?”

Conclusion

Investing in natural resource stocks offer strong inflation protection, high dividend yields, and are generally selling at depressed valuations, making this appealing as part of a diversified portfolio for long-term money. Companies with pricing power also offer good inflation protection, but their valuations are priced at higher multiples of their earnings with potentially less opportunity for appreciation than natural resources from current levels.

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