With large US deficits, trade deficits, the quantitative easing already performed by the Federal Reserve, easy money policies, and worldwide debt concerns, investors may rightly be cautious regarding the potential for inflation over upcoming years. Even optimistically, if economic growth picks up, that may allow inflation to finally take hold after it has been potentially building up due to these various policies.
There are several types of investments, however, that respond reasonably well to inflation. I don’t advocate market timing, or trying to tailor a portfolio to deal with very specific concerns, so here I present three investments that are useful in a variety of portfolios and that also respond well to inflation. It’s a fairly quick overview.
Stocks, in general, are decent investments to hold over the long term during periods of substantial inflation. When prices are going up, it’s these businesses that are raising their prices. Periods of short-term major inflation can be bad for pretty much everything, including companies, but over the long-term, stocks hold up pretty well with regards to inflation. This applies to companies in general, but there are some specific types of companies that respond best to inflation.
-Companies with significant economic advantages, or moats, typically have good pricing power and can raise their prices accordingly.
-American companies that sell a significant portion of their products and services overseas in different currencies get “bonuses” when the US dollar falls. A company that has its expenses in a weakening currency, and revenues in strengthening currencies, reports growth that exceeds its “real” business growth due to positive currency effects.
-Foreign companies that primarily operate outside of the US are buffered against US dollar inflation.
-I don’t include commodities as a separate category in this article, but companies that deal with commodities and basic assets are sometimes suited for inflation.
2) Real Estate
Real estate, either in the form of personal or investment property holdings, or Real Estate Investment Trusts (REITs), is typically a good portfolio addition for inflation. The primary reasons are appreciation and leverage.
-When a property is located in a good area, it will hopefully appreciate over the long term, at a rate that either equals or preferably exceeds inflation. But considering that properties are typically purchased using debt, this effect is amplified. For example, if you put 30% down on property, and take out a mortgage for the rest, you control the whole property despite only having partial equity. This means that your gains on your equity are amplified when the property as a whole increases in value (or the opposite when the property decreases in value).
-If debt is fixed-rate, such as with a fixed rate mortgage or with a REIT that offers fixed rate notes, inflation is good for those that owe this debt. Inflation can help reduce the debt compared to asset value, meaning that debt as a percentage of assets will decrease because the asset side is partially indexed to inflation and the liability side is not. Real estate is typically more comfortably leveraged than many other things, so the effect of inflation on their debt is more noticeable.
3) Treasury Inflation Protected Securities
Most diversified portfolios include a bond segment, but a key risk for bonds is inflation. Treasury Inflation Protected Securities (TIPS) are bonds issued by the treasury that change with expected inflation. It’s perhaps not a bad idea to have a portion of your bond holdings in TIPS to protect that aspect of your portfolio from inflation. Compared to regular bonds, however, TIPS are a risk during rare periods of deflation.
-Having a ton of money in cash is not optimal in a period of inflation, and there’s almost always some level of inflation. Parking assets in an account that offers a yield lower than inflation means you’re specifically agreeing to a negative return on value in exchange for perceived safety. And you’re getting taxed on this negative return. It’s important to have a robust liquid emergency/savings fund, but apart from that, putting too much of a portfolio into cash equivalents can concentrate inflation risk.
-Precious metals like gold, or other commodities, typically respond well to inflation, but I believe that cash-flow-generating assets are better in general. I think there’s a lot more priced into gold than just inflation; there’s also a tremendous amount of fear and uncertainty regarding the global economy.