Protecting Investments From Inflation
Today we’re going to continue our conversation about inflation and protecting investments.
Just last week, another inflation announcement was made – this time at an annual rate of 3.6% which is up .2% from the previous announcement. These gains were mainly due to increases in energy costs, shelter, and vehicles.
The background of these increases is pretty interesting. The rise in energy prices is due to increased demand and some supply issues caused in the States and abroad.
Similarly, the rise in vehicle prices is tied to demand increases and the shortage of semiconductor chips. These chips are used in all aspects of vehicles and the lack of them is helping push up the price of vehicles.
Overall, Statistics Canada hasn’t been too concerned about these inflation numbers as these price increases are being compared to pandemic prices that were lower than normal. They also point out that many current prices are still less than the pre-pandemic levels.
The story so far is that we still don’t know if these inflationary effects are going to become ingrained or are transitory. Hopefully the latter, but only time will tell.
What we see is that much of this inflation has been twofold – we see increased demand by consumers as we emerge from the COVID-19 health crisis and massive supply disruptions of raw material that occurred during the pandemic. These effects then push up prices.
Inflation – What Are Real Rates?
So to understand the impact of inflation on our investments it’s important for us to first understand the concept of real rates.
Generally when we see annual returns on holdings these are called nominal rates – the rate or expected rate that we are going to receive. Now because inflation reduces the value of money overtime, the we can adjust the interest rate to show the effects of inflation.
This is called the real rate and is the rate that you receive with expected inflation removed.
There are a couple ways to calculate this but the easiest way is to just subtract expected inflation from the nominal rate. A more complicated method is called the Fischer Equation.
The ultimate goal is to have holdings with a positive rate – if not than the value of your wealth is decreasing over time.
So for example, a savings account would have a real rate of negative 2% if the nominal rate is 1.25% and expected inflation is 3.25%
I’m not going to talk about it here, but taxes would further reduce your returns as well.
Should You Protect Your Investments From Inflation?
Before we dig into how to protect against inflation, it’s important to understand that inflation hedging is one variable in your decision making process and it may not make sense for you.
Many of the inflation hedging methods use investments that have greater risk involved which may not be suitable for all financial goals or people. So before you jump into any products, it’s important to make sure that it works for you and it’s always a good idea to speak to a financial professional.
Protecting Investments with Growth Equity
So one of the most common ways to hedge against inflation is through equity – either directly with stocks or through a fund – like an exchange traded fund or low-fee mutual fund.
Historically, the nominal returns on stocks have outpaced inflation. The reason for this is that companies are also affected by inflation and will often make adjustments to avoid it.
This adjustment is usually done by increasing prices to pass along the costs to clients. These increased costs typically come from inputs like raw materials and labour. We’re also already seeing this happen too – companies like Coca-cola and Whirlpool are already planning to increase the costs for their goods.
The increased prices allow them to pass along increased expenses so that they can maintain their profitability.
Now, the interesting thing is that there can be a point where companies cannot pass price changes to customers anymore, which can then reduce profitability and negatively affect stocks.
Certain industries also have advantages over others. For example – banks, healthcare, food, and others are more insulated against inflation than other companies.
It’s also important to point out that growth-based equity can perform better than dividend paying stocks as dividends can become less attractive when rates on other investments become more competitive.
Precious Metals and Commodities
Another common investment to hedge against inflation are precious metals and commodities.
Gold and silver are historic hedges against inflation and have been the typical go to during past periods of inflation. The most common way to invest in these holdings is through buying physical investment grade precious metals or buying an investment that holds these.
These investments can also track the direct commodity itself or in the companies that are in the related industry.
It’s important to point out that precious metals and commodities are highly volatile. For example, the price of gold skyrocketed during in the years after the great recession due to inflation concerns and only has surpassed its previous highs 10 years later.
Real Estate & REITs
Another historical way to hedge against inflation is through property. The way to do this is to have ownership of an existing property or by investing in a fund of some that invests in real estate – such as a REIT.
Now to add a couple dashes of realism – buying a property is exceedingly difficult to do in Canada right now and you have to prepare for all of the additional expenses and responsibilities that come along with the process.
Also, it’s questionable if commercial real estate is a good idea right now as we still don’t know if the demand for these properties will be sustained after things begin to normalize. Many businesses will likely stick with working from home structures in some capacity but the full impact is unknown at this point.
What About Crypto Currencies?
The final category that may hedge against inflation are crypto currencies. There are quite a few different crypto products out there but the largest and most well known is Bitcoin.
Proponents of crypto believe that it could be the new hedge against inflation and this does make some sense. However, the truth is we just don’t have enough historical information on whether or not this wil transpire.
What we do see is that crypto is very volatile and the value has been dropping while the inflation concerns have been increasing – which is not a good sign.
There may be inflation hedging aspects but one worry is if this effect is being drowned out by other market effects.
Either way this is definitely one to watch to see how it acts in the future.
Investments to Avoid During High Inflation
Traditionally, one of the most sensitive investments to inflation are bonds – with an emphasis on bonds with longer time periods.
The way that bond prices move can easily confused new investors but the basic idea is this – most bonds have set interest rates that are part of the contract. If all of a sudden, inflation increases then new will be issued with higher interest rates to remain competitive.
This then means that the bond with the lower interest rate is not as attractive as the higher rate bond and to compensate for this the price goes down for the one with the lower rate.
The opposite is also true, bond prices will usually go up as inflation decreases.
Now, not all bonds are equal – historically, long-term bonds are more sensitive to rising rates than shorter-term bonds. There are even some bonds that have variable interest rates that change with market rates.
Most investors will have a percentage of bonds if they have a diversified investment portfolio – especially if it’s a singe fund portfolio.
Another investment in Canada that is really affected by inflation are GICs. The problem here is that most GICs have fixed rate periods that can last for up to 5 years. Those that hold their funds here are very susceptible to inflation as their holdings can be stuck – meaning that they will often receive a negative real rate for a set period of time. Often holders can break their GIC contracts, but they can sacrifice returns if they do such.
In reality, most issued gics have low rates to start with and usually a negative real return. This can further aggravate the issue.
And the final holding category that we’ll cover are savings accounts and chequing accounts. Chequing accounts typically pay next to zero and savings accounts can about 1.25% if you shop around. The negative real rate here can be quite severe.
Now, it’s important to point out that it’s recommended to keep funds in a high-interest savings account if it’s an emergency fund, you need extra liquidity, or you have a financial goal that is quickly coming up.
But never, ever leave large amounts of savings in a chequing account – It’s easy to fix this and you can easily earn some extra interest elsewhere.