Inflation Hedging Your Portfolio

How to hedge against inflation must be most asked question about investing of 2021.  It fortunately happens to be one of the most easily answered.  The answer itself though, is a little more complicated than many people expect.

The first thing to realize is that once inflation is making headlines, the best opportunities have passed.  It’s almost as bad as trying to buy insurance on your home once it’s already caught fire.  Consumer prices and wages sit at the tail end of the inflationary bucket brigade.  When inflation is showing up there, it’s already been around for a long time.  This is why you see so many articles supposedly debunking the effectiveness of this or that investment in hedging inflation.

When interest rates are cut and the presses start rolling, inflation starts.  There is no lag.  Asset prices in real time markets rise immediately.  Stocks for instance reprice in real time, tick by tick.  Wages don’t.  And since consumer prices depend heavily on wages, they don’t either.  The effect may start to seep in shortly after inflation begins, but the lion’s share of it takes years.

The1970s for example are remembered as an inflationary decade.  But most the inflation had already occurred in the 1960s, during the “guns ‘n butter” era of the Vietnam War and the Great Society expansion of government social spending.  But it was asset prices that rose most; the 1960’s weren’t remembered for inflation, but for a bull market in stocks.  We instead remember the 1970s as the inflationary decade, because that’s when most of the price effects of inflation finally hit wages and consumer prices.

This is one reason inflation is so pernicious … at first it just looks like prosperity.  Our most popular gauges of inflation just look at consumer prices, so they don’t notice.  Inflation is popular in the early stages, so there’s little pushback against it.

But if you think about it, it’s not possible for asset prices to rise indefinitely without consumer prices eventually catching up.  After all, assets are really only worth what you can buy with them.  A 50% rise in the stock market at the same time as real GDP rises 5% is 45% inflation.  Either asset prices must fall or consumer prices rise to meet them … or some messy combination of both.  That’s what happened in the 1960s & 1970s.

We saw the same movie again in the 1990s & 2000s.  There was a great inflation during the 1990s.  The stock market ended in a bubble.  The next decade saw two major bear markets interceded by a huge inflation in house prices and energy prices.  It’s not widely remembered, but crude oil hit $147 a barrel in July of 2008, right on the precipice of the worst deflationary crash since the Great Depression.  A messy combination of both.

We saw a shorter term example of this in the wake of the 2020 corona crash.  Interest rates were slashed to zero and the printing presses started rolling in late March 2020.  Inflation didn’t start making headlines for another year, but gold prices rocketed higher for a mere six months.  Stocks held out for most of the twelve.  But by the time year over year CPI prints were sounding the alarm, most of the gains were over.

So how to hedge inflation?  Stocks.  Commodities.  Real estate.  But if you’ve waited until inflation is making headlines, the early bird has already gotten the worm.

What to do then?  It depends on how much inflation is still ahead at the source.  To the extent policymakers begin to respond to inflation concerns, more cash and bonds may be appropriate.  Consumer price inflation can continue for a long time after it’s left the asset price building, and there is no good way to invest for consumer price inflation itself.  It’s not on the asset menu.  Even TIPs, indexed to the CPI, compete with nominal bonds and their prices will already have risen to the point they no longer have an advantage … they outperform only when the CPI rises more than the market already expects.  At this point a more balanced approach consistent with your long term outlook and goals is appropriate.  

 

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