Investment Strategies to Hedge Against Inflation
In March 2022, inflation in the U.S. surged by 10%, the hottest inflationary trend since the Carter presidency.
Wholesale prices are climbing, putting a pinch on investors. Food, energy, and retail trade margins are all going up. Groceries and fuel are squeezing the budgets of many American households.
All these cost increases have investors asking: What is the best investment hedge against inflation?
Let's take a look at what inflation is, how it affects everyday investors, and the best investments to guard your wealth against inflation.
What is Inflation?
The International Monetary Fund defines inflation as, "The rate of increase in prices over a given period of time."
For most citizens, inflation is simply the broad measure of the cost of living increase in their country. That's a good definition.
Economists use a more specific measuring stick, however, called consumer price inflation (CPI).
If you wanted to calculate CPI, you would start with a basket of commonly purchased goods and services. Weigh the value of each good or service with housing usually getting the heaviest weight. Then, calculate what percent change is required to purchase that complete basket of goods over a specific period of time.
If you have a CPI of 10% in two years, for instance, then it costs 10% more to buy that basket of products and services than it did two years ago.
How do we know we're living in an inflationary period? Well, former President Ronald Reagan cut to the chase when he said of inflation, "We all know we're very much worse off." “Very” may be a strong word to describe today’s environment, but there’s no getting around it - inflation can quickly sneak up on you.
It’s the Starbucks cup of coffee that used to cost $2.50, but now costs almost $3.
What Causes Inflation?
There are a number of factors that can cause inflation in an economy, but it’s generally supply and demand.
Too much supply and not enough demand produces a state of disequilibrium called excess economic supply. In this environment, and prices fall sharply.
Sound good? It is… until wages fall right along with prices. That's tough. Everything keeps dropping until the economy achieves a balance between supply and demand again.
Inflation creates the opposite problem. Typically, it is caused by an increase in production costs (it now costs the company $10 to make the item), or due to a surge in demand. Consumers demand more than suppliers can produce. As a result, prices go up — and up and up and up — as far as consumers are willing to chase the products they want to buy.
What Are the Effects of Inflation
Inflation affects people, nations, and even the global economy. Most of the effects of inflation are negative.
The most obvious effect is that inflation begets more inflation. As consumers spend more and more quickly, they can cause prices to increase faster and faster. Eventually, this can cause hyperinflation when every payday turns into a spending frenzy.
Another effect of inflation is that it can raise the cost of borrowing. In Q1 of 2022, the Federal Reserve had already increased interest rates by 0.6%, which was the first bump in three years. Raising interest rates helps to cool off spending and borrowing, but it can also dampens loan-driven markets like real estate.
Inflation means your dollar no longer goes as far. Your $300 grocery bill, might start to look more like $350. So assuming your employer has not increased your base salary, that means you likely have less to spend each month. The budget you built at the beginning of the year might require some shifting, and hopefully you have some excess that can help ease this burden. However, if you’re living paycheck to paycheck inflation could mean you have real problem.
One of the largest risks for a new retiree is inflation. If you’re pulling income from your investment portfolio you’re more sensitive to the loss of purchasing power of the liquidity part of your portfolio. You need your investments to keep up with inflation. You’ll likely also be looking to increase the amount you are withdrawing from your investments, or make a change to your budget and current lifestyle.
Does Inflation Offer Any Benefits?
Surprisingly, inflation isn't all bad.
For one thing, it helps protect against deflation or oversupply. Inflation can also reduce the cost of borrowing and even help bring down unemployment.
In general, however, inflation is considered an economic woe and not a boon.
What is the Best Investment Hedge Against Inflation?
The word inflation scares many everyday investors. And for good reason - especially as a retiree, or if you have cash sitting under your mattress. In all cases, you likely want your money to keep up with inflation.
During an inflationary period, many people turn to what they perceive as inflation-resistant assets. These can include gold, commodities, some bonds, real estate, treasury inflation-protected securities (TIPS), and stocks.
Let's look at a few of these assets in more detail:
Gold
Gold is sometimes named as the ultimate hedge against inflation. Most people don't buy gold bullion or bars these days. Instead, investors purchase ETFs that hold gold as their underlying asset.
Once upon a time before 1971, this strategy made a lot of sense. Back then, the U.S. dollar was backed by gold. Thus, gold was a stronghold against inflation, and in some cases providing decent growth. However, in today’s market this isn’t necessarily the case. Since the first Nixon administration, gold has lost its glitter. From 1990 to 2020, the price of gold gained 360% while the broad US stock market, as measured by the Dow Jones Industrial Average, increased by 991%.
Historically, Gold has in some cases acted as a short-term hedge against a bear market, but it might not necessarily be a long-term investment strategy to grow your retirement wealth.
Commodities
Commodities are the raw materials for basic goods used in commerce and traded on an exchange. Examples of commodities include electricity, oil, beef, corn, wheat, natural gas, metals, and foreign currencies.
The price of commodities generally heralds the coming of inflation. As the cost of wheat or natural gas goes up, so will the cost of bread and heat.
Some people love buying commodities. Most modern investors don't go to an auction and bring home tubs of oil or a few beef cattle to graze in their backyard. Instead, they’ll invest in stock or ETFs that hold ownership of select commodities.
For unexpected inflation commodities may in fact provide some hedge against inflation, Vanguard recently completed a study which found this to be the case. However, commodities have historically also been more volatile than other types of investments.
Remember when oil and gas were sitting in tankers off the coast because it cost more to unload them than the commodity was worth? Or the rise of current oil prices. Which has largely been affected by Russia’s invasion of Ukraine. That's what we mean by volatile assets. You can win a lot, but you can lose a lot too.
One twitch in the geopolitical landscape can cause commodities investors to lose their shirts. So as an investor you might consider if there’s a better way to accomplish your goal.
TIPS
Treasury inflation-protected securities (TIPS) are a type of U.S. Treasury bond indexed to inflation. Meaning the principal value of TIPS rises as inflation rises. TIPS come in five-year, 10-year, and 30-year maturities and pay out twice a year based on the inflation rate. In theory this sounds like the answer, but TIPS also have some potential shortcomings too.
In today’s environment, such inflation protection is highly valued. As a result TIPS aren’t necessarily providing the type of inflation protection one would want right now. In other words, TIPS tend to be better when no one was expecting inflation.
There's some truth to the perception of security, but in general, these investments have underperformed other traditional bonds when inflation is low, and have radically underperformed stocks, over the long term.
So what is the best investment hedge against inflation?
There is no ideal choice, and each investor needs to base their decision on their investment preferences, goals and risk tolerance. However, one thing that is worth noting - over long periods of time, stocks have continually outperformed inflation. Which means if you’re in a well diversified portfolio you may already be positioned to help protect against inflation.
The Importance of Staying the Course
Keeping a well thought-out strategy on track can be one of the most challenging and the most important parts of being a successful investor.
As a long-term investor, staying the course often means being patient and disciplined. It's investing with your head and not your emotions. Often the best thing to do in times of uncertainty is to call your advisor, revisit your strategy if needed, and stay the course.
Proverbs 16:32 reminds us that self-control or control over our emotions can be a rare gift, one better than being an acclaimed soldier. "Better to be patient than a warrior, and better to have self-control than to capture a city." - we can’t control the markets, but we can plan ahead and control our reaction.
Short-term, investments such as gold, commodities, and TIPS can feel good — and can even be good — for the short term. If you're investing with an eye beyond the immediate future, however, a well thought-out diversified portfolio is likely your best bet. In some cases that diversified portfolio might event include a portion of gold, commodities, or TIPS.
Talk to your wealth management advisor about developing the right portfolio for your income needs and your family's future. Contact Cooke Wealth Management to talk with one of our advisors about how you can build an inflation-resistant wealth management strategy.