Inflation Ahead?

IN THE INVESTMENT world, inflation is the topic of the day. There are four key reasons:

• Congress. Since March 2020, the federal government has dropped more than a trillion dollars of cash into the economy via stimulus checks and the Paycheck Protection Program. While many of the recipients were unemployed and needed these dollars to meet basic needs, others were not. The result: More money in people’s pockets allowed them to spend more, pushing up prices for many products. Many of these stimulus dollars also found their way into the stock market, which has helped lift share prices. This newly created wealth, in turn, has helped drive up prices for some big-ticket items, including houses.
• The Fed. Last year, the Federal Reserve announced a policy shift. Going forward, the central bank plans to put less emphasis on controlling inflation and more emphasis on maintaining full employment. The Fed will, in fact, permit inflation to run a little hotter than it might have in the past. In recent statements, Federal Reserve Chair Jerome Powell reiterated this stance, even as he acknowledged that super-low interest rates and a recovering economy are causing prices to rise.
• Fear. In recent years, inflation has been very low by historical standards—often below 2%. Still, it wasn’t all that long ago that inflation was north of 10%, contributing to the economic malaise of the 1970s. We’ve all read about the disastrous effects of high inflation in other countries. When Congress recently approved plans to spend another trillion dollars on infrastructure and other initiatives, people started worrying more.
• Expectations. Since the pandemic began, the Federal Reserve has held its federal funds rate near zero and has communicated that it plans to leave it at that level for at least a few more years. What do interest rates have to do with inflation? Implicit in the Fed’s position is the belief that the economy will remain weak enough to require the support of continued low interest rates. By extension, if the economy is weak, inflation should also remain low. That’s the Fed’s view. But investors seem to disagree. From a low around 0.5% last summer, the rate on 10-year Treasury notes climbed above 1.7% in recent weeks and ended Friday at 1.59%. When market interest rates jump like this, it’s an indirect sign that investors see inflation coming. In other words, investors aren’t buying the Fed’s assertion that inflation will remain low in the coming years.

If there’s reason to believe that higher inflation might be on its way, how can you protect your portfolio? Below I’ll describe how inflation normally affects three key asset classes: bonds, stocks and gold.

Bonds. Because most bonds make fixed interest payments, they’re a poor investment when inflation starts rising. The only exceptions are floating-rate bonds, which are somewhat rare, and a few flavors of U.S. government bonds, including Treasury Inflation-Protected Securities (TIPS), which I recommend. TIPS are directly tied to the consumer price index. This guarantees that their interest payments will keep up with inflation.

How exactly do TIPS work? Twice a year, the government adjusts the price of TIPS bonds. When inflation is higher, it marks the price up. Interest payments are then recalculated using the bond’s new, higher price. But TIPS aren’t an entirely free lunch. When there’s deflation, the government marks down the price of TIPS bonds, resulting in lower interest payments. Upon maturity, however, holders never get less than a bond’s original principal value.

When you buy a TIPS bond, there is an inflation rate implied—often called the “breakeven rate.” Today, that breakeven rate is around 2.3%. If inflation turns out to be higher down the road, you’ll do better with TIPS than with regular Treasury bonds. On the other hand, if inflation is lower, you’ll be worse off. That’s why I recommend diversifying, holding both standard and inflation-protected bonds.

If you own a total bond market fund, it’s important to know that these funds don’t include TIPS. They include only standard Treasury bonds. If you own only a total market fund, I would supplement it with a separate TIPS holding.

Stocks. These are much more resilient when inflation strikes. To understand why, consider this thought experiment: Suppose you’re the chief executive of an auto manufacturer. In ordinary times, it costs you $20,000 to make each car. You then add on 50% for the company’s profit and sell them for $30,000. If you sell a million cars a year and earn $10,000 on each, your total company profits will be $10 billion.

Now suppose inflation hits, and suddenly your costs rise by 25%. Instead of $20,000, it costs you $25,000 to build each car. To maintain the same profit margin, you tack on 50% and sell each one for $37,500. If you still sell a million cars, but your profit margin is now $12,500 per car, your total company profits will rise to $12.5 billion. That’s exactly 25% higher than your company’s profits were before inflation struck. And since—all else being equal—share prices follow corporate profits, your company’s stock price should also rise by 25%, right in line with inflation.

This is a simplified example, but that’s the basic idea. As long as a company can raise its own prices to keep up with inflation, its stock price should keep up with inflation as well. To be sure, there are caveats. Some companies will find it harder to raise prices. But overall, stocks are, in my opinion, investors’ best protection against inflation.

Gold. In the 1970s, when inflation was running high in the U.S., gold enjoyed a golden era, climbing from about $100 per ounce in 1976 to more than $700 in 1980. Ever since, gold has enjoyed a reputation as an ideal hedge against inflation. But unfortunately, it’s also been a poor long-term investment. Following that peak in 1980, gold dropped—and took 27 years to reclaim its prior high. On top of that, aside from that one period in the 1970s, gold has demonstrated very little correlation with inflation.

As I’ve noted before, gold lacks intrinsic value, meaning that it doesn’t generate any income. That’s in contrast to other major types of assets. Many stocks produce dividends, bonds produce interest and real estate produces rent—but gold produces nothing. That’s why it shouldn’t be any surprise that its price meanders aimlessly over time, much like bitcoin, and for the same reason. Both are viewed as inflation hedges. But in both cases, I believe it’s a mirage.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. In his series of free e-books, he advocates an evidence-based approach to personal finance. Follow Adam on Twitter @AdamMGrossman and check out his earlier articles.

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