How to Tackle Inflation

I just paid $100 for a chocolate bar!

Some of you may remember when inflation hit double digits in the ’80s. Back then, paying 15% on your mortgage was reasonable, and Canada savings bonds were doubling your money every five years. When the cost of goods goes up, it has many effects. Only time will tell if $100 chocolate bars will happen in our lifetime, but one thing is certain: they will cost more. Inflation is currently one of the hot-button topics, so we figured we would provide some context on how we believe investors can tackle it in their portfolios.

 

What is inflation?

Before we can protect against it, we must know what inflation is. In the simplest terms, inflation is what happens when the purchasing power of our money decreases. As inflation increases, we can buy less stuff with the cash we have.

• Inflation example: Let’s say on January 1^st it costs $2.00 to buy a medium Tim Horton’s coffee. You can walk into a Tim’s and buy that coffee with a Toonie. If inflation for that year is 5%, then on January 1^st of the following year, that Tim’s coffee now costs $2.10. Unfortunately, the Toonie that sat in your pocket is still only worth $2.00, and therefore you cannot purchase the coffee. I.e., the purchasing power has decreased due to inflation!

 

Is Inflation Bad?

The short answer: Not entirely. A moderate amount of inflation is a sign of a healthy economy. The current target for inflation is 2% per year, and this would represent a reasonable amount of growth in the demand for and prices of goods & services.

However, inflation does have the potential to become troublesome. There are two possible “bad outcomes”:

• Low Inflation or Deflation
  • If demand for goods and services is too low, that will create low inflation. This can slow economic growth because businesses do not see the incentive to operate because they’ll need to cut costs or lay off employees. If this spirals out of control, it can lead to a recession with more drastic increases in unemployment.
• High Inflation
  • If inflation runs too high, the purchasing power of our dollars drastically decreases and can affect the economy and its constituents. For example, if inflation outpaces wage increases, then individuals will, in theory, become less wealthy.

 

How Does Inflation Affect Your Investments?

Inflation is not necessarily “good” or “bad” from an economic perspective, but it should not be ignored from an investment perspective. If your investment portfolio earns 10% in a year, but inflation for that year was 2%, your real return is 8%. Intuitively, we can understand that a higher inflation rate will drag on our investment returns since our returns are calculated net of inflation. With that intuition, investors tend to seek investments that provide a hedge against inflation.

 

Hedging Against Inflation

To find the perfect hedge for inflation, we’d need an investment that:

1. Correlates positively with inflation
2. Isn’t super volatile
3. Has a positive real expected return

Unfortunately, an investment that meets all these criteria does not exist. The three often discussed as a potential hedge are Real Return Bonds (or TIPS in the U.S.), Gold, and Cryptocurrencies. Let us briefly explore these three investments.

1. Real Return Bonds

These are the Canadian equivalent of Treasury Inflation-Protected Securities (TIPS) in the U.S. These Real Return Bonds are very similar to a government bond. The difference is that the principal value fluctuates with increases or decreases in inflation, thereby protecting from the effects of inflation.

This investment provides some inflation protection, but investors must consider the following:

• • The interest rates offered on Real Return Bonds are usually lower than other fixed-income investments that do not have an inflation adjustment (opportunity cost).
  • The market for real return bonds is limited.
  • The durations of these bonds tend to be long, which increases the risk to investors (higher interest rate risk, the longer the duration).

2. Gold

The typical sentiment is that gold is a good inflation hedge because it is a store of value. However, research has shown that there is nothing inherent in gold that ties it to inflation. If we look at a period from 1978-1995, where inflation was extremely high, we see that the price of gold was highly volatile and did not keep pace with the consumer price index:

 

*Source: Askola, Jussi – Seeking Alpha

 

There could be an argument that when investor sentiment is that inflation is looming, money flows into gold which temporarily drives the price higher. But unless you actively trade in and out of the position (which is very challenging to do successfully consistently), gold does not appear to provide a perfect inflation hedge.

3. Cryptocurrencies

Cryptocurrencies are a new asset class, so there is a limited amount of history to draw on to make any conclusions about its ability to provide an inflation hedge. A few things stand out in recent history that works against crypto in this regard:

• As mentioned, to be a strong hedge against inflation, an investment would require a strong correlation with inflation. However, the opposite appears to be the case. When the Consumer Price Index data released in May signaled high inflation, bitcoin experienced an approximately 30% decline in value.
• Crypto is also one of the most volatile asset classes in the market today, and its future price is very uncertain. For this reason, we do not believe it be considered a store of value or a good hedge for inflation.

 

What Works?

A few things to consider helping tackle inflation:

• Inflation is not necessarily a global phenomenon. For example, suppose inflation runs high in the U.S. This does not guarantee that inflation will run high in the U.K. or elsewhere in the world where different currencies are used. Diversifying your portfolio outside of your home nation and into the global economy can help reduce your exposure to high inflation domestically.
• The long-run average for inflation is 2%, and the long-run average return for stocks is approximately 8%. If your investment horizon is for the long-term and you are currently concerned about inflation, holding a diversified portfolio of stocks is something to consider.

 

Summary

We do not believe there is a perfect inflation hedge available. Without proper due diligence, you may take a step backward by abandoning your current strategy or put yourself in a situation where you are taking on unnecessary market risk. That being said, there are ways to add a moderate amount of “inflation favoring” investments to a portfolio without taking you off track.  Meeting with your advisor to determine if this is right for you would be a prudent approach. The inflation winds are starting to blow, and you need to be prepared.

 

Sources:

https://www.nber.org/system/files/working_papers/w18706/w18706.pdf

https://www.investopedia.com/articles/investing/092514/better-inflation-hedge-gold-or-treasuries.asp

https://www.investopedia.com/terms/i/inflation.asp

https://www.downtoearth.org.in/news/economy/inflation-is-healthy-for-the-economy-but-too-much-can-trigger-a-recession-65058

https://www.investopedia.com/terms/d/deflation.asp

https://apnews.com/article/financial-markets-inflation-health-coronavirus-pandemic-business-9b28c435bcaf8f787838ca1160e4d47f

https://www.investopedia.com/terms/t/tips.asp

https://www.bankofcanada.ca/rates/interest-rates/canadian-bonds/

https://www.cansofunds.com/canadian-inflation-and-the-prospects-for-real-return-bonds/

https://seekingalpha.com/article/4426543-why-gold-is-a-poor-inflation-hedge