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If Inflation is Coming, Here is What to Do About It Thumbnail

If Inflation is Coming, Here is What to Do About It

If Inflation Is Coming, Here Is What to Do About It

Investing to protect a portfolio against the likelihood of rising prices is harder than it looks

The single most important question in investing this year is whether the rampant inflation of the moment is temporary, as the Federal Reserve believes, or marks a historic shift. I argued last week that we are on the cusp of a major change and long-run inflation is now more likely. 

How best to protect a portfolio against the losses that rising prices often inflict? 

The interplay of timing and uncertainty prevents there being a single simple answer. However, there are useful strategies that can be put to work now. If you agree that inflation is more likely, it is important to act, as ordinary bonds are awful investments under inflation, while stocks overall have been poor. 

Here are five approaches, along with their biggest risks:

1. Golden Rule

Ask on social media how to protect against inflation, and the answer is simple: Just buy gold. Not so much this year, when the price of gold has fallen as inflation doubled from 1.3% to 2.6%. But it is true that gold, historically, has performed well when inflation is high, holding on to its value even in countries where inflation soared into double-digits, according to a study for Credit Suisse by academics Elroy Dimson, Paul Marsh and Mike Staunton.

The trouble with gold is that in normal times it tends to do significantly less well than stocks and doesn’t provide an income. Because gold’s value is underpinned by the notion that other people believe it to be valuable, it is also vulnerable to anything that threatens that status. I think thousands of years of history give it solid support, but it is possible that the rush to bitcoin could disrupt it.

2. Commodities as Classic Inflation Hedge

Inflation means rising prices, and commodity prices usually rise the most, as it takes a long time to build new capacity to satisfy the demand. Shares of miners, oil drillers and other commodity producers haven’t done so well as raw material prices during inflationary periods in the past, but still outperformed the rest of the market. Copper and oil are up more than 30% this year and lumber has almost doubled, while stocks of global mining and major oil companies have strongly beaten broader indexes. The trouble with commodities is that unless you have an oil tanker or a gigantic warehouse, they have to be bought through futures contracts, whose long-term returns depend more on the difference between various futures prices than the underlying commodity. The danger is what traders call contango, when prices are higher the further ahead the futures contract matures. Contango means a long-term investor is constantly buying high and then later selling low, making a negative “roll” return. Put another way, if the market correctly anticipates inflation, there is no extra money to be made betting on that inflation. Copper, the biggest industrial metal future, is already in contango, so an investor has to think that prices will rise enough to cover the regular losses on the roll.

3. Stocks With Low Pricing Power

This is the exact opposite of what shareholders usually look for in a company. Firms with in-demand products can raise prices come what may, so attract premium valuations. But when prices are rising everywhere, the weaker, less popular companies can also price more aggressively, and pricing power becomes less important. In such an environment there is no point paying a premium valuation for pricing power, so cheap, or “value,” stocks in fiercely competitive sectors such as telecommunications or cable TV become more attractive. Ben Funnell, a multiasset fund manager at Man Group, says these low-pricing-power stocks outperformed for roughly the first three-quarters of each inflationary episode in the U.S. since its entry into World War II. But once investors started to anticipate the end of inflation the stocks fell hard and, over inflationary periods as a whole, actually underperformed. So while value and low pricing power offer the potential for inflation protection, they need active monitoring.

4. Treasury Inflation Protected Securities

TIPS are the single best source of inflation protection as their coupons and repayment at maturity are directly tied to consumer prices. Unfortunately they are expensive, with 10-year TIPS paying 0.9% below inflation. Inflation needs to rise at least that much over the decade just to maintain purchasing power. If inflation fears pick up, TIPS prices are likely to rise as more people buy them. But for investors who hold them to maturity the best return they can get is inflation, minus 0.9%. One limited alternative: U.S. individual investors can and mostly should have the maximum $10,000 a year in series I Treasury savings bonds, whose interest rate adjusts with inflation, but never goes below 0%.

5. Assets With Short Duration

Assets which rely on returns far in the future will be hit by rising fears of an inflationary spiral, and those with fixed returns—bonds—will be hurt the most. The 30-year Treasury yield is up from a low of just over 1% at the height of the panic in March last year to 2.3% today, but that apparently small rise conceals a loss of more than 20% in price, because of the long duration. Something similar applies to growth stocks, which promise larger profits far in the future and so look less attractive in an inflationary environment. That provides another source of support for value, which tends to offer more immediate rewards. American homeowners have an easy way to take the other side of duration in the form of the 30-year fixed rate mortgage—which comes with a free option to refinance if inflation never arrives and yields fall. Inigo Fraser-Jenkins, a strategist at Sanford C. Bernstein, points out that long-duration assets are hit not only by inflation itself, but also by rising uncertainty about inflation, which makes them less appealing.

Putting It All Together

The biggest problem investors face is to create a portfolio that will be able to cope with inflation but not lose horribly if the Fed surprises everyone and jacks up interest rates to kill inflation. The Fed’s change in approach makes this less likely than in the past, but it remains entirely plausible, and would hurt almost any bet on inflation returning. What steps are you taking to protect your portfolio against inflation? Andrew Parker at Horizon Kinetics developed an exchange-traded fund that attempts to avoid this problem by buying stocks with exposure to what he calls “spread” earnings. These include owners of royalties, as well as financial exchanges that should benefit from market volatility induced by inflation. He argues that in ordinary times they will do fine and if there is inflation they should outperform, even if stagflation appears. But it is new and untested, and even if it works, it is a compromise: The returns from these stocks are likely to be less exciting than the rest of the market in normal times, and less rewarding than outright inflation bets if inflation appears. Some sort of compromise is inevitable, because there is no perfect portfolio that wins big whether inflation appears or not.

from THE WALL STREET JOUNRAL, May 11, 2021, By James Mackintosh