The Federal Reserve is closely watching several key economic indicators right now to see whether inflation will rear its head any time soon. And if inflation does appear, the Fed has shown signs that it will raise rates slowly in an effort to stave off market volatility. But the job market may continue to improve, and prices may keep rising, which means that bond prices will drop as investors flee fixed-income instruments, whose value erodes in inflationary times. What’s an income-oriented investor to do?
Shifting funds from bonds to stocks, especially preferred shares, is one strategy.
Real estate usually performs well in inflationary climates; REITs are the most feasible way to invest.
Adding global stocks or bonds to your portfolio also hedges your portfolio against domestic inflationary cycles.
Another option is more exotic debt instruments, like bank loans and TIPS (inflation-adjusted Treasury bonds).
A disciplined investor can plan for inflation by cultivating asset classes that outperform the market during inflationary climates. Although traditional bonds are the usual go-to for the income-oriented, they aren’t the only investment that produces a revenue stream.
Here are the top five asset classes to consider when seeking protection from inflation. They range from equities to debt instruments to alternative investments. All are feasible moves for the individual investor to make, though they carry different degrees of risk.
If inflation returns, it’s generally a punch in the jaw for the bond market, but it could be a shot in the arm for the stock market. Consider reallocating 10% of your portfolio from bonds to equities in order to take advantage of this possible trend.
Utility stocks represent a third alternative, where the price of the stock will rise and fall in a somewhat predictable fashion through the economic cycle and also pay steady dividends.
There are several major economies in the world that do not rise and fall in tandem with the U.S. market indices, such as Italy, Australia, and South Korea. Adding stocks from these or other similar countries can help to hedge your portfolio against domestic economic cycles. Bonds from foreign issuers can likewise provide investors with exposure to fixed income that may not drop in price if inflation appears on the home front.
Real property often acts as a good inflation hedge, One of the easiest ways to get exposure is through real estate investment trusts (REITs), which own portfolios of commercial, residential, and industrial properties. Providing income through rents and leases, they often pay higher yields than bonds. Another key advantage: Their prices probably won’t be as affected when rates start to rise, because their operating costs are going to remain largely unchanged.
Treasury inflation-protected securities (TIPS) are designed to increase in value in order to keep pace with inflation. The bonds are linked to the Consumer Price Index and their principal amount is reset according to changes in this index.
TIPS’ yields have dropped in value in the secondary market considerably since 2018. They may be a good bargain at this point, as they have not yet priced in the possibility of inflation.
Senior secured bank loans are another good way to earn higher yields while protecting yourself from a price drop if rates start to rise. The prices of these instruments will also rise with rates, as the value of the loans increases when rates start to rise (although there may be a substantial time lag for this). The Lord Abbett Floating Rate Fund (LFRAX) is one good choice for those who seek exposure in this area.
Many of these investments are complex instruments, and novice investors may be wise to buy them through a mutual fund or exchange-traded fund (ETF). For example, the Vanguard Global Ex-U.S. Real Estate Index (VNQI) offers broad-based exposure in properties around the world. The iShares TIPS Bond ETF (TIP) tracks the performance of inflation-protected U.S. Treasury bonds. The Lord Abbett Floating Rate Fund (LFRAX) is one good choice for those who seek exposure in lower-grade corporate loans.
The best hedge against inflation, historically, depends on your time frame. Commodities are often cited as a good bet for keeping up with the cost of living–especially gold. However, research by Duke University professor Campbell Harvey and Claude Erb, a former commodities and fixed income manager at TCW Group, shows that gold works best as an inflation hedge only over the very long-term–a century or more.
Many analysts and economists feel equities are a better way to protect your portfolio over the long term, particularly against an unexpected flare-up of inflation. Corporate earnings often grow faster when inflation is higher, because it indicates people are spending and the economy is growing. While it has its ups and downs, over the past 100 years, the stock market (as represented by the S&P 500) has appreciated an average 10% annually.
One of gold’s traditional selling points has been its status as an inflation hedge. As an actual, tangible asset, gold tends to hold its value for the most part–unlike paper currencies like the dollar, which lose purchasing power when inflation is rampant. There’s an old saying that the price of one ounce of gold equals the price of a quality business suit. That held in 1934 when suits went for $35, and with gold currently around $1,800 an ounce, it does today, too (assuming that suit is by Ralph Lauren).
With rising inflation, gold typically appreciates. However, gold isn’t a perfect inflation hedge. Other factors can drive its prices, which can fluctuate wildly from year to year–which means its inflation-adjusted returns can too. In fact, over the last 1-, 5-, 10-, 15- and 20- year investment horizons, the variation in the nominal and real returns of gold has not been driven by realized inflation.
Theoretically, bitcoin could be a strong inflation hedge. Assets that investors run to in times of rising prices–so-called safe-haven investments like precious metals and real estate–are ones that are scarce or move counter to paper money or financial assets. Bitcoin fits the bill.
The problem is, bitcoin hasn’t much of an investment history: Created in 2009, it’s only been actively traded for a decade or so, and inflation hasn’t been much of a factor for most of its short life.
So no one really knows how inflation will affect bitcoin and its characteristically volatile behavior. Certainly, its performance has been puzzling vis-a-vis inflation of late. Bitcoin doubled from mid-December 2020 to early January 2021, as inflation started to heat up. But then, with no apparent easing of inflationary pressures, between Jan. 8 and Jan. 11, it lost 25% of its value.
In May 2021, inflation talk intensified: As the Federal Reserve signaled a retreat from easy-money pandemic policies and a rise in interest rates, stocks trembled–but bitcoin really tumbled. On May 19, it culminated a month-long slide by closing at $38,390–a 41% decline from its peak of $64,829 in mid-April.
Real estate is one of the time-honored inflation hedges. It’s a tangible asset, and those tend to hold their value when inflation reigns, unlike paper assets. More specifically, as prices rise, so do property values, and so does the amount a landlord can charge for rent, so that the property earns higher rental income over time.
There’s also the phenomenon of “depreciating debt”: that is, the cost of the real estate owner’s mortgage payments actually declines. For example, say your mortgage payments add up to a fixed $8,333 per month during the first year of your loan. They will remain the same nominally–$100,000 annually– but may well only be worth $80,000 in the 10th year, if there’s been sustained inflation during that period.
All these elements make real estate valuable protection in inflationary times.