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Best Investments for Inflation Protection

First, a history lesson. Back in 1973 when Nixon abolished the gold standard, inflation peaked at 9% and began a swift contraction towards 4.75% over the following two years.  Monetary policy was adjusting to the new reality of a U.S. dollar-backed only by the full faith of its government, leaving businesses confused and prices high.  What followed was a rapid ascent for U.S. inflation to a peak in 1980 at 18%.  Around the same time, the yield on the US 10-year Treasury bond reached an astounding 15.95%!  Said differently, in 1981, you could buy a bond maturing in 10 years and earn nearly 16% each year for the next 10 years with little to no risk to your investment.  These days, who could say no to that?!

Unfortunately, the days of double-digit yields on treasury bonds are long behind us.  Though for the individuals who purchased these bonds in the early 80s, they reaped the benefits long after inflation dropped from its peak.  Not only did those investors continue to earn close to 16% interest every year on their original investment, but they also saw the price of those bonds increase as inflation fell back towards 4% only 10 years later.  Since this period, bond investors have primarily been winners as interest rates have steadily decreased.  Though some investors fear the tide may be turning, and interest rates could be nearing an inflection point.

It’s important to consider inflation through a historical lens when determining what investments we could use to protect ourselves from inflation today.  The chart included above would suggest we’ve had a difficult time stirring inflation beyond 3% for any significant period going back to the 1990s.  However, we’re also living through unprecedented times in various ways as global economies continue to grapple with pandemic-induced recessions and their subsequent recoveries.  In the U.S., Monetary and Fiscal policy are expected to remain loose with little regard for near-term inflationary pressures.  The Fed has made it a point to allow inflation to run above its long-term target of 2% as a way to “catch up” for below-average inflation in the past.

In this context, many worry inflation must be coming as prices for many goods have seemingly skyrocketed in the past twelve months, and policy accommodation shows no signs of tightening.  Legendary investor Warren Buffett recently warned of inflation as they saw input prices increase for many of the companies owned by Berkshire Hathaway.  “We are seeing very substantial inflation,” remarked Buffett at their annual shareholder meeting.  “We are raising prices.  People are raising prices to us, and it’s being accepted”.

Industrial companies are seeing higher commodity prices and are being forced to pass those costs along to consumers.  And for anyone building a home these days, the cost of lumber alone has become almost prohibitively expensive (see below).

Source: NASDAQ Commodities – Lumber (LBS)

As investors, what are some of the best investments we can use to help protect ourselves from inflation?  The good news is that there are certain asset classes we can look at that have traditionally done a good job at dampening the negative effects of inflation.  The bad news is that there’s no silver bullet with which to achieve this protection.  As is often the case with investing, there are various factors at play when attempting to plan for combating inflation.  We’ll review some traditional, alternative, and for those more prone to accept the risk, speculative ideas to keep in our inflation protection quiver.

Traditional

Treasury Inflation-Protected Securities (TIPS)

TIPS are one of the most common investments to own for investors seeking out inflation protection.  In a fundamental sense, the price of a TIPS bond will increase as inflation increases.  The coupon paid to the investor will also increase as inflation increases.  Inflation for TIPS is defined as increases in the Consumer Price Index (CPI), and coupons are paid semi-annually.

The benefit of TIPS in an inflationary environment is evident.  If the CPI rises, your TIPS will also increase in value.  When inflation is persistent and increasing, TIPS are a great investment to own.  The drawbacks of owning TIPS are often a lower interest rate relative to a fixed-rate bond if inflation doesn’t materialize.  Additionally, in a deflationary environment, TIPS bonds can have their coupons reduced.

Real Estate

Over more extended periods, your home tends to be a great protector against inflation.  As input prices rise for constructing new homes, this makes the demand for existing homes greater.  Combine rising input costs with current demographic trends showing more individuals seeking to buy single-family homes and you can see how homeownership benefits an individual’s net worth during periods of inflation.

Similarly, even if you don’t own a home, you can invest in companies that own real estate.  These Real Estate Investment Trusts, or REITs, provide investors with a way to access both the commercial and residential real estate markets as a way to diversify their portfolios.  In most cases, REITs will provide an above-average level of income while also serving as an efficient way to help protect against rising inflation.

Stocks

For certain stocks, inflation can be a negative.  Traditionally, stocks that depend on a steady stream of dividend payments as a basis for their valuation can be hurt during periods of rising inflation.  Utility companies are a good example of this type of stock.  This is because utility stocks are seen more like a long-term bond due to their consistent, low-growth income stream, and bonds with longer maturities are often negatively impacted significantly more than shorter-maturity bonds during periods of rising inflation.

Alternatively, stocks with little reliance on steady dividend payments can appreciate nicely, assuming they can pass along increased input costs to consumers.  Companies within the energy, materials and healthcare sectors can see growth during inflationary periods as demand for these goods tend not to be too sensitive to increased prices.  Owning a diversified basket of stocks across all sectors can help investors protect against expected and unexpected inflationary pressures.

Alternative

Commodities

Getting into less traditional asset classes, commodities are often cited as great inflation protectors as their prices will increase as demand, and subsequently, inflation increases.  While it’s a bit harder to own commodities directly (I don’t think anyone wants to stockpile barrels of oil in their backyard), you can get exposure to certain commodities through Exchange Traded Funds (ETFs).

One of the nice features of commodities as an asset class is that their price increases are often a leading indicator of inflation to come.  Using oil as an example, as more Americans travel, this can place upward pricing pressure on gasoline which causes inflation if supply can’t keep up with demand.  Owning companies in the energy sector can provide investors with indirect exposure to oil demand without the hassle of purchasing derivative contracts on the commodity itself.

Gold

This glistening asset is often cited as a “go-to” inflation protector when in reality, it has a shaky track record at best.  During certain time periods, gold has produced stellar results, though you need to go back to the 70s and 80s to find a stronger correlation between gold prices and inflation.  More recently, gold has been used as a hedge against broader market volatility.  Though here again, gold’s track record has been questionable depending on your time horizon.

The primary reason gold isn’t a perfect inflation hedge is that as inflation increases, central banks will increase interest rates to combat inflation if they deem inflation to be getting out of control.  Higher interest rates are a net negative for gold prices as investors can earn more through collecting income through higher-yielding securities than they can on the expected price appreciation of gold.  During periods of uncertainty, gold can be a good diversifier in a portfolio, but it’s no panacea against inflation.

Speculative

Cryptocurrencies

For those more willing to throw caution to the wind, the burgeoning yet still infantile world of cryptocurrencies could be a source of inflation protection.  Using bitcoin as an example, crypto investors believe this currency can protect against inflation in the U.S. dollar, specifically because it is not controlled by any sovereign government or entity.  By being “decentralized” and out of the hands of the regulators, the thought becomes Bitcoin will survive, if not thrive, during inflationary periods as consumers get rid of their U.S. dollars and purchase Bitcoin instead.

There are many, many “ifs” to this line of reasoning, and Bitcoin is still in its early years as far as broad consumer adoption is concerned.  Only a handful of major American companies will accept Bitcoin as a form of payment, though more are expected to accept it in the near future.  It’s important to remember that in the world of crypto, prices can move fast, unpredictably, and wildly without warning.

Conclusion

A dollar today will not have the same purchasing power as a dollar 10 years from now.  This will be true even if inflation “only” manages to average 2% per year.  It’s also why financial professionals encourage individuals at all levels of wealth to consider investing as a way to keep ahead of inflation and maintain their purchasing power into retirement.  Using some of the asset classes above in conjunction with a well-diversified portfolio can help protect your purchasing power and grow your wealth into and throughout retirement.

Disclosures

Bernicke does not make any representations as to the accuracy, timeliness, suitability, or completeness of any information prepared by any unaffiliated third party, whether linked to or incorporated herein. All such information is provided solely for convenience purposes, and all uses thereof should be guided accordingly.

Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Great Valley Advisor Group, a registered investment advisor, Great Valley Advisor Group, and Bernicke Wealth Management are separate entities from LPL Financial.

All investing involves risk, including loss of principal. No strategy assures success or protects against loss.

Treasury Inflation-Protected Securities, or TIPS, are subject to market risk and significant interest rate risk as their longer duration makes them more sensitive to price declines associated with higher interest rates.

Investing in Real Estate Investment Trusts (REITs) involves special risks such as potential illiquidity and may not be suitable for all investors. There is no assurance that the investment objectives of this program will be attained.

The fast price swings in commodities will result in significant volatility in an investor’s holdings. Commodities include increased risks, such as political, economic, and currency instability, and may not be suitable for all investors.

Precious metal investing involves greater fluctuation and potential for losses.

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