Finance

Inflation Defense: Five Strategies To Consider (And A Bonus)

On December 14, 2021, the Bureau of Labor Statistics (BLS), released data about a significant increase in the Producer Price Index (PPI), the largest increase since the data was first calculated in November of 2010. For the 12 months ending November 2021, the PPI was up 9.6%. PPI is important because it measures the average change in prices received by producers for many products and some services. As the chart below illustrates, there is no question we have some form of inflation. The question is. How do we play defense?

Why Inflation Matters. Inflation is critical to our retirement planning considerations because it sets our ‘real rate of return’, or what we make after inflation. So, if our portfolio is making 3% and inflation is 3%, we are standing still. If inflation is 6% and we’re making 2%, we’re going backwards. Here’s a chart from the Fed to show the Treasury rate minus CPI. Note that we’re in the negative territory:

Components matter. Inflation has been with us about as long as money has existed. Inflation is a measure of purchasing power. Traditionally, there are three versions of inflation: Demand-pull, where there is more demand than production capacity (think cars both used and new, or houses); Cost-push, where the cost of raw materials increases prices (e.g., steel being up several hundred percent); or Built-in, where wages rise as prices rise (real wages are up as a result of the employment situation).  For 2022, it appears all three types are present. Whether this is ‘sticky’ or ‘slippery’ (or both) remains to be seen. In either case, we should consider defensive tactics.

Defense, defense. There are a variety of ‘normal’ defensive tactics for inflation investing. These include:

·       Treasury Inflation Protected Securities (TIPS)

·       Gold

·       Small Cap Stocks

·       Natural resources

·       Real estate

TIPS: Standard Defense. This solution, invented specifically for the purpose of offsetting inflation, is called Treasury Inflation Protected Securities (TIPS). According to Treasurydirect.gov, “Treasury Inflation-Protected Securities, or TIPS, provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater. TIPS pay interest twice a year, at a fixed rate. The rate is applied to the adjusted principal; so, like the principal, interest payments rise with inflation and fall with deflation.” In short, a TIPS is a Treasury Bond that is indexed to inflation, where the principal is adjusted to reflect increases or decreases based on the CPI. TIPS pay interest twice a year, and the interest is based on the adjusted basis, so it can vary.

The coupon rate doesn’t change, but the payment does.  Individual TIPS are available direct from the Treasury or are most often bought through a fund or ETF. This sounds easy, so why wouldn’t everyone hedge inflation with TIPS? The answer is ‘negative yield curve’. As of 12/15/21, a 5-year TIPS had a yield of -1.41%, while a 30-year had a negative yield of -0.35%. The negative yield is attributed to the rate on regular treasury bond being lower than the rate of inflation. So, holding individual TIPS will protect against inflation if they are bought directly from the Treasury and held to maturity. On the other hand, a TIPS fund or ETF can buy or sell TIPS at any time, causing the prices to be volatile. As of 12/15/21, the 10-year performance of the iShares TIPS Bond ETF was 3.26%.

Small, But Mighty Bonus: I-Bonds. Another inflation-protected Treasury security with some strong inflation-protection properties is the I-bond. Unlike a TIPS, an I-bond pays interest based on a fixed rate plus the rate of inflation. As of 12/15/21, I-bonds pay an initial interest rate of a remarkable 7.12%. This rate is good through April 2022. I-bond interest is federally taxable, but not subject to state and local income taxes. You can cash them in after 1 year at face value. If you cash them before 5 years, you lose 3 months of interest. They can be bought electronically through Treasury Direct, up to $10,000 per calendar year.

Gold: All That Glitters. Gold is historically regarded as an inflation hedge, although it is probably better characterized as a currency hedge. There are a number of ways for investing in gold, ranging from the base metal, or an ETF that buys the base metal like GLD; to buying gold mining stocks or a fund or ETF that buys miners. But is it a hedge? On August 15, 1971, Richard Nixon announced that he had taken the US off the gold standard. Since that time, we’ve had some serious bouts of inflation. According to a study by Robert Arnott, gold sometimes worked and sometimes didn’t:

During the 1973-79 timeframe. Gold handily outperformed inflation, REITs, and Commodities. However, in the next two rounds, 1980-84 and 1988-91, gold actually has a negative return during inflationary periods. If we measure from the time the US dropped the gold standard, Gold returned, from 1971-2019, 10.61%, slightly less than stocks or commodities. For a fun look at gold over 3,000 years, have a look at Claude Erb’s paper.

Small Cap Stocks. The theory here is simple: small companies are more nimble and can pass on price increases to customers more easily. History seems to bear this out when we compare inflation-adjusted returns from 1969:

Natural Resources. Natural resources are also widely considered an inflation hedge since raw material price increases tend to correlate with inflation. There is a difference between the underlying commodities and commodity producers. Producers tend to behave more like stocks. In the 1973-79 high inflation period and in 1988-1991, commodities outpaced inflation. In the period 1980-1984, commodities had a positive return, but failed to keep up with inflation.

Real Estate: They Aren’t Making Any More of It. In each of the three higher inflation periods in the last 50 years, only Real Estate Investment Trusts (REITS) have provided a return greater than inflation. Real estate rents and real estate values tend to rise in inflationary times, which gives a REIT a steady cash flow stream. REITs can be invested in though the REIT itself, or through a fund or ETF. REITs have special tax treatment as well, which can change the after-tax return in taxable accounts.

Bottom Line: Diversify. Whether we are in a period of sticky or slippery inflation (or both), diversifying makes sense. Remember to rebalance your portfolio, maybe shifting some weight to small caps, real estate, and commodities. Also, don’t forget the I-bond: 7.12% on a government security is pretty darn good. As always, I’ll try to answer questions: [email protected].


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