In June 2022, the U.S. recorded an annual inflation rate of 9.1 percent, the highest rate in over 40 years. There are many complex and variable reasons behind this figure, but there is no doubt as to the impact – this is detrimental to the economy and makes the investment environment more difficult, but not impossible.
In this article, we'll talk about investing in an inflationary environment, including why it's difficult and which investments are doing best.
In the end, readers will be better informed about the risks and challenges associated with investing in a high inflation cycle and will be able to use this information as part of their due diligence process before investing.
What is Inflation and Why Does It Matter?
Before discussing the details of investment in an inflationary environment, it is logical to define this term and highlight why it is important.
What is Inflation?
Inflation is the gradual increase in commodity and service prices over time. In a very simple example, look at the price of a bottle of Coke over time.
At the time of its introduction at the end of the 1880s, the price of a 6.5-ounce bottle was 5 cents. In 2022, the price of a 12-ounce bottle ranges from $1.50 to $1.75 – a significant increase over time, likely because of rising costs of raw ingredients, transportation, land, and overhead anagnorisis. Inflation is measured by the development of what is called the Consumer Price Index (CPI), which is a "measure of the average evolution over time of prices paid by urban consumers for a market basket of goods and services". In general, the Federal Reserve is attempting to maintain a target inflation rate of 2-3 percent per year, well below the 9.1 percent rate in June 2022.
Why Is It Important to Invest During Inflation?
High inflation rates have a large impact on the economy for several reasons, but there are three that are most noticeable. First, it diminishes a person's ability to buy money. At 9.1 percent annual inflation, an individual who does not do anything with his money loses 9.1 percent of his purchasing power in one year. Over several years, this loss can be devastating, especially for pensioners with fixed incomes.
Second, this means that investors must obtain a higher return on their assets simply to maintain the same level of purchasing power. For a given year, a return on investment of 9.1 percent would be quite good, but inflation of 9.1 percent means that investors do not make a return on their investment after deducting inflation. To go forward, they would have to beat that number, which can be a challenge.
Finally, and perhaps most importantly, it means the Federal Reserve will be acting— via monetary policy – this can have adverse effects on the economy. The Federal Reserve's main tool in combatting inflation is interest rates. When inflation is high, they will increase it, making it all more expensive, and causing a decline in economic activity. Thus, the main challenge for investment in an inflationary environment is that the Federal Reserve may take measures to deliberately reduce demand, which may hurt investment performance.
Protecting Your Finances in An Inflationary Environment
For investors, the key to protecting their finances in an inflationary context is to ensure that their assets are performing above the rate of inflation. To demonstrate this, consider two scenarios in the context of 9.1% annual inflation.
In scenario #1, an investor has all their capital invested in a portfolio of bonds including US treasuries and high-yield bonds because they like the relative safety and the income provided by the coupon payments/dividends. This portfolio has a very respectable annual return of 6 percent. In most years, this would be very good, but in a year with inflation of 9.1%, this investor has effectively lost 3.1% net of inflation.
In Scenario 2, investors take more risk and place their capital in a basket of individual shares, REITs, ETFs, and an antinatural fund. This portfolio is yielding 12%, which sounds great, but it truther setosity’s 2.9% net of inflation. The point is this, to protect their assets during a period of high inflation, investors must lead their capital towards assets that will produce a return greater than inflation. In general, this means moving away from relative bond security toward more risky assets like equities, index funds, mutual funds, and real estate or REITs that can outperform inflation.
What are the best investments for inflation?
Generally, the best investments in times of rising inflation are those with price-fixing power to track businesses that can to the price of their goods and services to keep up with inflation.
There are a couple of first-order examples that fall into that category.
Real Estate
Real estate assets, particularly income-generating assets, are a typical example of an asset class that can be a good hedge against inflation. There are a couple of reasons.
First, homeowners can charge higher prices as inflation increases. Of course, there may be contracting constraints in this regard, however, when leases need to be renewed, lease rates can be adjusted to the current market rate, reflecting the effects of inflation.
Secondly, inflation increases the cost of everything, including real estate. So, the combination of the ability to increase cash flow and higher prices means that real estate can be an excellent place to put money aside in the context of high inflation.
Commodities
A commodity is an economical asset that can be purchased or sold. Often, the basic products are agricultural or raw materials that are used to produce other things. There are examples of products such as maize, wheat, precious metals, oil, and natural gas. Commodities can offer good inflation coverage as their prices also increase during periods of inflation. A good example is the price of softwood lumber, which has skyrocketed in the last few years from $536 per 1,000 board feet to $1,441. This is higher than inflation. For retail investors, the direct purchase of raw materials can be challenging. But you have mutual funds or sectoral ETFs that are exposed to commodities that are probably more appropriate.
Bonds
For the most part, bonds are not a great option in times of high inflation. However, there is a type of bond, called "Bonds", which can be bought directly from the U.S. Treasury and whose yield is linked to inflation. The exact calculation of yield can be complicated, but the performance of “Bonds” includes a fixed-rate component that is linked to the rate of inflation which is reset at regular intervals. At the time of writing, the interest rate paid on the bonds is 9.62%, which is a very strong performance, mainly because it is supported by the US government. Moreover, there is another type of obligation, called Treasury Inflation Protected Inflation-Protected Security TIPS. Like a “Bond”, these are securities bought directly from the US Treasury and whose yield is related to the rate of inflation. For investors who prefer relative bond security, both types can be an option that deserves to be added to an investment portfolio.
Stocks/Equities
From a risk perspective, equities are in the upper range, but this level of risk may be required to outperform inflation. However, not all stocks are created equally. The threat of higher interest rates is negative for growth actions like those of the technology industry. At the same time, value stocks and those paying healthy dividends are likely to be better suited to an inflationary environment. For example, a technology company like Uber that relies on low-cost capital to grow its business is much more likely to suffer under higher rates, than a regular dividend payer such as Walgreens, whose business is less leveraged at low cost and more stable throughout the business cycle. Of course, it is important to note that all elements above are meant to be general. To get accurate advice, it's always a good idea to work with a financial adviser. Can help make specific allocation decisions based on an individual's risk tolerance, time horizon, performance targets, and personal investment strategy.
Advantages and Disadvantages of Investing During Inflation
Each challenge is an opportunity and there are pros and cons to investing in times of strong inflation. The biggest advantage is that investors with patience, discipline and a clear strategy can find great deals in equities, bonds, and real estate that have been hammered by the macroeconomic environment. In addition, dividend income can assist investors until inflation is contained. The most significant drawback is volatility. The stock exchange and the economy generally do not like the uncertainty caused by inflation. In many cases, there are two major concerns: (1) to what extent will interest rates rise; and (2) to what extent will these higher rates negatively affect economic growth? As responses to these questions become clearer, volatility tends to decrease, but this can take months or years. So, investing in an inflationary environment requires patience and conviction in the investment strategy to make it through a better time.
Summary of Investing During Inflation
Inflation is defined as the gradual increase in the prices of goods and services over time, as measured by the development of the Consumer Price Index (CPI). The Federal Reserve has a responsibility to keep inflation within a target range of 2% to 3% per year, but there are moments when it falls outside that range and their main tool to get it back online is to raise or lower interest rates. When inflation is high, interest rates rise, thereby dampening demand and bringing inflation back to a normal level. However, this general downturn in economic activity could negatively affect overall economic conditions. When inflation is high, investors need to take steps to safeguard their finances against the erosion of purchasing power. In many cases, this means migrating capital to investments that tend to be good inflation coverage such as real estate, commodities, “Bonds” and value stocks with strong dividend payouts. The main advantage of investing in an inflationary environment is that investors can find bargains in certain asset classes, but it may take a little patience and discipline to keep going until the economic conditions get better. The disadvantage is that an inflationary environment is volatile.
In previous post: "What is the Investor’s Guide to the Ground Rent Capitalization Method?"