Inflation is here: How to tailor your investment strategy
Last week, the US labour department reported an inflation rate of 4.2% from April 2020 to April 2021. This is significant because it’s the highest month-to-month jump since September 2008, during the very midst of the global financial crisis.
It also reflects a broader trend of governments around the world making upward adjustments to long-term inflation expectations. In fact, we may be entering a period of structurally higher inflation that investors haven’t been exposed to since the 1980s.
In this article, I’ll explain what this shift means for the economy and how you can tailor your investment strategy to accommodate this new normal.
What is inflation?
Inflation represents the decrease in the purchasing power of your money as consumer prices become more expensive relative to cash. A recent example of this is data showing that second-hand cars in the US became 10% more expensive in April relative to March. So if you were looking to snag a car in March and hesitated, well now the same product is going to cost you 10% more, just one month later. So why does inflation happen?
Inflation occurs when the supply of consumer goods in the economy becomes lower relative to demand. If you think about the two sides of the equation as a scale, this can happen when either the supply decreases, or when the demand increases. COVID-19 has been a catalyst for both.
COVID-19 has been a catalyst for [inflation].
Here’s what I mean. On the supply side, the pandemic placed severe limitations on the chain of production of many consumer goods. For example, the discovery that meat-processing facilities were highly vulnerable to COVID transmission caused many factories to either shut down completely or implement processes that decreased output. In general, the fact that combatting COVID requires social distancing means that most chains of production will be similarly affected, creating what’s known as a bottleneck effect on the chain of production.
On the demand side, the pandemic initially lowered spending as it physically denied customers the ability to shop offline while also mentally encouraging people to save for a rainy day. But now that recovery prospects have improved, what we’ve seen is a release of pent-up demand from all those rainy day accounts. This is compounded by governments around the world printing money and placing it into the hands of citizens, exemplified by the US’s $1400 stimulus cheques to Americans. This is known as an increase in the money supply.
With this knowledge in mind, how do you tailor your investment strategy to maximise real returns?
Allocating investments in an inflationary environment
We now know that a dollar today will be worth less than a dollar tomorrow. The ability to rapidly adjust prices to account for this change - thus preserving the purchasing power of income (without losing demand) - is known as pricing power. Different players within the economy have different degrees of pricing power - the higher your pricing power, the better shielded you are from the effects of inflation.
The rule, then, is to find investments that have the flexibility to quickly price inflation into its income stream while being able to resist inflation being priced in to its expenses. This allows the company or asset you invest in to capture the value of any shift in purchasing power.
find investments that have the flexibility to quickly price inflation into its income stream
Let's assess a number of asset classes using this paradigm.
Commodities represent the classic form of inflation hedge, characterised by gold. Due to the proximity of commodities to economic inputs and chains of production, commodity suppliers command a high degree of pricing power. The correlation between inflation and growth in commodity prices is reflected (non-exhaustively) in oil, natural gas and minerals.
Inflation has a two-fold effect on equities. First, higher inflation prompts central banks to increase interest rates in a bid to maintain a low inflation environment (generally accepted to be best for long-term economic stability). This in turn increases the 'risk-free' or 'discount rate' used to assess the present value of future cash flows - as higher-yielding investments become available today, the opportunity cost of waiting for future cash flows increases. Second, the faster pace at which purchasing power diminishes over time leads to future income becoming less valuable than present income.
The combined result of these two factors means that companies whose valuations are predominantly based on present or near-term income will be better insulated than companies whose valuations are based primarily on future expected earnings. Broadly speaking, value stocks (with lower P/E ratios) are better insulated from inflation than growth stocks (higher P/E ratios).
Even where rate adjustments do not occur - as may well be the case given the prevailing need for economic recovery - inflation raises the expectation of future adjustments, which is itself enough to weigh on valuations.
Real estate often appreciates alongside high inflation. Landlords derive pricing power from the ability to increase rent, and renters are willing to pay more as money supply increases. In turn, rental yield increases, leading to further capital appreciation. Note that real estate investment is not limited to purchasing houses. Real estate investment trusts (REITs), for example, are a great way to gain exposure to the market that doesn't require large amounts of capital to start.
The limited nature of Bitcoin's supply is the basis for claims that cryptocurrencies serve as an inflation hedge. On the surface, this claim is accurate - limited supply creates a disinflationary/deflationary environment, which better preserves/increases a currency's purchasing power over time, all else held equal. There are three caveats to this rule.
First, not all cryptocurrencies are deflationary. As of May 2021 only 5 of the top 10 cryptocurrencies by market capitalisation are de/disinflationary, the other 5 have uncapped supply and are designed to be inflationary, similar to fiat money.
Second, cryptocurrencies remain highly volatile relative to traditional investments. As such, they are not suitable as inflation hedges per se, where the aim is stable value preservation.
Third, compared to commodities, crypto as an inflation hedge is not tried and tested. With just over a decade of price history, the crypto sphere has barely experienced one economic cycle. More empirical data is required to ascertain the extent of correlation between crypto and inflation.
Fixed-income instruments should be avoided in inflationary environments, as pricing power is non-existent.
In sum, grasping the concept behind inflation and the rule of pricing is essential to investing in an inflationary environment. It's especially important to be humble in the face of the unknown, as structural shifts could alter fundamental assumptions about correlations between asset classes.