We have discussed inflation on this blog for some time. After some engagements with my readers over the course of the last few months, it has become evident that more is needed to unpack the ‘How’. I’ve just wrapped recording of our next podcast on this very topic. It will drop on Thursday.
Long time readers of the blog will know my views that inflation as a ‘rate of change’ is transitory. However, they will also know that I am cognizant that absolute price levels may well be sticky. As such, there will be a step change in the price of many goods and services.
This step change will result in winners and losers as with many economic cycles. The purpose of this post is to unpack what investing for inflation would look like. The simple fact is that no one can unequivocally ‘know’ what is going to happen with inflation. The best we can do is assign probabilities to our views and allocate capital accordingly.
Inflation targeting and rates
It stands to reason that in an inflation targeting framework, that as inflation ticks higher, that the policy reaction function would be to increase interest rates. The Fed has indicated that rates will likely remain contained for some time to come, creating a short-term asymmetry.
However, the paring back of stimulus coupled with recent lows on US yields, may all give way to some higher yields in the short to medium term. I wrote on this about a month ago when yields were even lower than they are now. Check it out. And tactically if the 10 year breaks above 1.50%, 2% would easily be the next support level.
In this construct, bonds would be a bad investment given the capital risk associated with higher yields. There are inflation protected securities to consider like TIPS. If you are just discovering my content and are also new to yields, bonds and how this works, check out the Yield Masterclass podcast here. I also discussed some ETF’s I looks at as a means to execute on some of these macro views in this podcast (How we use ETF’s).
What about Gold?
Long term followers will also know that I like gold. It’s not because it’s a great inflation hedge. It hasn’t been in the short term. It’s a doomsday hedge and where others like a tin foil hat, I prefer mine to be gold. 😊
Gold’s relationship with inflation has been relatively unstable. The correlations tend to oscillate between periods of a ‘reflation trade’ to a ‘deflation trade’. This has been evident in the near term as gold has significantly underperformed other asset classes which have taken the mantle of ‘inflation hedge’ of choice. Think crypto and even just stocks.
Are all stocks created equal?
In an equity centric world, it is worth while looking at what stocks and sectors tend to perform better under rising inflation environments.
The chart from Schroders above is a neat representation of the ‘winners/losers’ construct I mentioned earlier. It is equity specific and would exclude the fixed income plays I discussed earlier. However, we could look at the ‘Mortgage REITS’ in the lower left quadrant as a proxy for fixed income.
Precious metals and mining represent the ‘ad hoc’ relationship I spoke about in that it is a coin toss in ‘whether’ it beats inflation, but when it does, it runs hard.
Energy in the top right, appears to be a strong contender. Structurally, energy represents a large portion of expenditure and feeds through into inflation across the board, so it would stand to reason that it would have one of the strongest relationships.
As an aside and a topic for another day. my larger concern is that in a world transitioning toward clean energy, that we curtail investment in conventional energy but are unable to replace it with alternative energy fast enough, resulting in supply bottlenecks and inflation. This would be a risk I keep on the radar along with other key supply chain bottlenecks (semiconductors, etc).
Hard assets in hard times
Equity REITs are a favorite of mine. There is something about a ‘bricks and mortar’ investment which assuages my underlying risk aversion. There’s just something to be said about ‘hard assets in hard times’.
While REITs in general may come under pressure in a higher rates environment as investors reallocate, there is an underpin of inflation adjustments to rentals over time as well as a tangible underpin to the NAV’s. The trick here is to ensure that you DON’T overpay for an asset.
The Equity REIT’s also play into another of the top right quadrant themes, consumer staples. Consumer staples are a defensive play. In inflationary times, investors would look to companies that have the ability to pass the higher prices onto consumers. This tends to hurt consumer discretionary and help staples. I would look to this underlying theme even when considering other sectors, like REITS etc.
‘Many ways to skin a cat’
I have no idea where that phrase comes from and it is kinda weird. But the point is that the ability to execute on a theme (like inflation) comes in many guises. It is not a ‘one size fits all’ approach. Investors would also do well to isolate what the driving factors are behind their ‘theme’.
For example, in inflationary times, high dividend payers tend to get hurt as investors reallocate to bonds and away from div. stocks. But value (or quality) tends to outperform growth. In this context, the chart above would be a good starting point to begin your own research process. But bear in mind that it may well overlook some opportunity.
For example, the ‘Financials’ sector on the cusp of the top right quadrant may mask the fact that some individual companies or subsectors, like insurers, may be geared to higher rates. It pays to scratch beneath the surface. If you enjoy this and haven’t discovered the Magic Markets podcast yet, check out our archive here. (We have something interesting coming soon so watch this space!)
The crystal ball
The fact is that no one knows what’s coming. The roadmap outlined above would hold true if inflation were to materialize. That said, bear in mind that notwithstanding the massive stimulus and low rates, that there is still a school of thought which considers that the world is merely facing ‘Japanification’.
If that is your view, you would probably be inversely positioned to everything outlined above. That’s the beauty of a market. It was Fitzgerald that said,:
“The test of a first-rate intelligence, is the ability to hold two opposed ideas in the mind, at the same time, and still retain the ability to function.”
That’s really what this juncture in the market feels like at the moment. It is why diversification is key and also why it pays to take a longer term and patient view while being cognizant of the world around us in flux and constantly changing….
These blog posts are commentary. There is ALOT more beneath the surface.
For more detailed and in depth analysis of macroeconomic and markets drivers, and what they mean for your business and strategy, please reach out at moe@moe-knows.com to discuss your needs.
