We’ve been talking about accelerating inflation here at Financology for several months. Let’s look at the investment implications. For inflation protection, portfolios need to contain commodities, value stocks, foreign stocks, and real estate.
Bonds are still important for risk mitigation and can add to returns through rebalancing due to low correlation with other portfolio assets, but are inflation losers and merit lower allocations than during the past four decades. TIPS do not remedy this deficiency, because of the point made earlier about the growth of the gap between the CPI and actual inflation. At the same time TIPS don’t provide the same protection in a deflationary crash as ordinary treasuries, as most recently demonstrated early last year, so are practically worthless for most investors.
Elementary commodities include both precious and industrial metals. These can be accessed in both physical form and via funds. Energy can be accessed either via futures funds or stocks. For agricultural commodities, I prefer farmland and forestry stocks over more direct exposure.
Like the elementary commodities, realty can be tapped in both physical and fund form. The most promising in my view include land and residential realty.
Timing is more complex. For now, the outlook is good for all of the above, but bears watching for signs the Fed’s patience is nearing its limits. The Fed has been like a broken record with its repeated statements that it wants higher inflation and expects to nail short rates to zero forever. But at some point not yet in view, it will come under pressure to act. Heck, even banana republic central banks eventually raise rates when inflation gets high enough. Now that the Fed seems determined to join their company, the most realistic expectation is that it will be well behind the curve in tightening, acting aggressively only when it comes to easing, as it has for years. Timing is something we’ll have to monitor in real time, but when rising prices are making headlines not only for stocks and houses, but gasoline, rents, utilities, groceries, etcetera, the Fed’s concern for its putative independence and the remains of its credibility will ultimately prompt it to act.
Then what? It’s too early for hard answers, but it seems likely that the Fed will very gradually, gingerly, tighten in the hope that inflation will ease gradually in kind. But that result won’t happen. Instead inflation will continue to rage as the Fed continues to tighten. Then it will unravel in a crisis, spiraling into a deflationary crash. This is after all what unfolded in 2003-2008. Due to the more forceful extent of intervention, however, the crisis is likely to be more severe than in 2008. Nevertheless that would be the preferable outcome. The worse outcome would occur if the Fed fails to timely tighten or remains too far behind the curve, and hyperinflation destroys what remains of the economy. This is hopefully unlikely, but the most important investments in such a scenario would be physical commodities.