Investing in an Inflationary Era

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.

4 thoughts on “Investing in an Inflationary Era

  1. Llanlad says:

    Quite the warning there Bill. I always thought talk of hyperinflation was hyperbole so to see it mentioned here is very sobering.
    You mentioned the timing issue wrt deflation and how it unfolded over 2003-2008. With the speed of this melt up in everything, but especially commodities and money supply have you got any thoughts (best guesses) how long this can go on for? It seems like 5 more months of this, never mind 5 years, and the dollar will be toilet paper if lumbar is anything to go by!!!
    Thanks for the article on gold vs copper it was very clearly explained and had a very real impact on my positioning. I’m a bit twitchier now though following this sudden recent run up in the latter.

    1. Bill Terrell says:

      I don’t mean to be hyperbolic … the word hyperinflation may seem so, but it’s not rigidly defined. It is a warning though … not in the sense that it’s imminent or likely, but possible if the policy mind set doesn’t change. Current monetary policy appears calculated to reduce the burden of accumulated government debt, but government debt itself continues to accelerate. It’s a startlingly reckless policy mix of positive feedback, a process capable of snowballing out of control unless firmly checked.

      I don’t know how long it could go on. The Synthetic Systems charts suggest possibly some time in the second half of this year or next. (The copper plot is broadly representative of industrial commodity prices.) We’re dealing with unprecedented monetary and fiscal policies though … in uncharted territory, so to speak.

      There is one factor that raises the possibility it could end very soon … the fact that inflation has now become headline material. It’s become a crowded trade. When too much capital is on one side of the boat, the boat can tip the other way at any time.

  2. Llanlad says:

    With regards to inflation protection of foreign stocks, is there a case to be made that it is US stocks that will do better in the inflationary episode as at least they represent something tangible in the economy while the currency is depreciated? It was certainly the case in Venezuala.

    1. Bill Terrell says:

      I wouldn’t necessarily consider US stocks more tangible than foreign stocks, but there’s no doubt US stocks are more overvalued. Implied prospective returns on foreign stocks are generally higher.

      Another factor is that US stocks tend to underperform when the dollar is weak in forex markets, or put the other way foreign stocks tend to outperform. But as inflationary policies are being followed throughout the “developed” world, whether the US dollar weakens against other developed world currencies isn’t clear. The “emerging” markets seem likely to offer the strongest long term prospects. Valuation however doesn’t offer much guidance shorter term.

      Nominal stock prices in Venezuela certainly did rise as the currency in which they’re priced plunged in value. A simple matter of it taking more units of the depreciated currency to buy the same stuff. Venezuelan stocks lost value, but the currency lost much more. Ergo, prices rose. But stocks outside of Venezuela rose even more in terms of the same currency, since they didn’t depreciate like Venezuelan stocks did.

      Bear in mind that most stock price “appreciation” is actually a figment of depreciating currency. This is apparent from a simple change of units. Price US stocks in ounces of gold instead of dollars, and you find they’re still below their year 2000 peak. Priced in copper, stocks have been in a bear market since February 2020.

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