Five strategies to consider (and a bonus)
On December 14, 2021, the Bureau of Labor Statistics (BLS) released data on a significant rise in the Producer Price Index (PPI), the largest increase since the data was first calculated in November 2010. For 12 months ending November 2021, the PPI was up 9.6%. The PPI is important because it measures the average change in prices received by producers for many products and some services. As the chart below illustrates, there is no doubt that we have some form of inflation. The question is. How do we play defense?
Why inflation matters. Inflation is central to our retirement planning considerations because it determines our “real rate of return,” or what we earn after inflation. So if our portfolio gains 3% and inflation is 3%, we stand still. If inflation is 6% and we gain 2%, we are falling. Here is a chart from the Fed showing the Treasury rate minus the CPI. Note that we are in negative territory:
Components matter. Inflation has been with us for as long as money has existed. Inflation is a measure of purchasing power. Traditionally, there are three versions of inflation: Demand-pull, where there is more demand than production capacity (think used and new cars, or houses); Cost pressure, where the cost of raw materials drives up prices (for example, steel being up several hundred percent); or Integrated, where wages rise with rising prices (real wages rise due to the employment situation). For 2022, it looks like all three types are present. Whether it’s “sticky” or “slippery” (or both) remains to be seen. Either way, we should consider defensive tactics.
Defense, defense. There are a variety of “normal” defensive tactics for investing in inflation. These include:
Treasury Inflation Protected Securities (TIPS)
Small cap stocks
· Natural resources
· Real estate
TIPS: Standard Defense. This solution, invented specifically for the purpose of offsetting inflation, is called Treasury Inflation Protected Securities (TIPS). According to Treasurydirect.gov, “Treasury Inflation-Protected Securities, or TIPS, provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the consumer price index.When a TIPS matures, you are paid the adjusted principal or the original principal, whichever is greater.TIPS pay interest twice a year, at a fixed rate.The rate is applied to the adjusted principal; thus, like the principal, interest payments rise with inflation and fall with deflation.” In short, a TIPS is an inflation-linked treasury bill, the principal of which is adjusted to reflect increases or decreases based on the CPI. TIPS pay interest twice a year, and interest is based on the adjusted basis, so it may vary.
The coupon rate does not change, but the payment does. Individual TIPS are available directly from the Treasury or are most often purchased through a fund or ETF. Sounds easy, so why wouldn’t everyone hedge inflation with TIPS? The answer is “negative yield curve”. As of 12/15/21, a 5-year TIPS yielded -1.41%, while a 30-year yielded negative -0.35%. The negative return is attributed to the fact that the rate for ordinary treasury bills is lower than the rate of inflation. Thus, holding individual TIPS will protect against inflation if purchased directly from the Treasury and held to maturity. On the other hand, a TIPS fund or an ETF can buy or sell TIPS at any time, which makes prices volatile. As of 12/15/21, the 10-year performance of the iShares TIPS Bond ETF was 3.26%.
Small, but powerful bonus: I-Bonds. Another inflation-protected Treasury security with strong inflation-protecting properties is the I-bond. Unlike a TIPS, an I-bond pays interest based on a fixed rate plus the rate of inflation. As of 12/15/21, the I-bonds pay an initial interest rate of a remarkable 7.12%. This rate is good through April 2022. Interest from I bonds is taxable federally, but is not subject to state and local income taxes. You can cash them after 1 year at face value. If you cash them before 5 years, you lose 3 months of interest. They can be purchased electronically through Treasury Direct, up to $10,000 per calendar year.
Gold: all that glitters. Gold has historically been considered an inflation hedge, although it is probably best characterized as a currency hedge. There are several ways to invest in gold, ranging from the base metal to an ETF that buys the base metal like GLD; buy gold mining stocks or a fund or ETF that buys miners. But is it a hedge? On August 15, 1971, Richard Nixon announced that he had taken the United States off the gold standard. Since that time, we have experienced serious bouts of inflation. According to a study by Robert Arnott, gold sometimes worked and sometimes it didn’t:
During the period 1973-79. Gold significantly outperformed inflation, REITs and commodities. However, in the next two cycles, 1980-84 and 1988-91, gold actually performed negatively during periods of inflation. If we measure from when the United States left the gold standard, gold returned, from 1971 to 2019, to 10.61%, slightly less than stocks or commodities. For a fun look at gold over 3,000 years old, take a look at Claude Erb’s article.
Small cap stocks. The theory here is simple: small businesses are more nimble and can pass price increases on to customers more easily. History seems to confirm this when we compare inflation-adjusted returns from 1969:
Natural resources. Natural resources are also widely seen as a hedge against inflation since increases in commodity prices tend to correlate with inflation. There is a difference between the underlying commodities and the commodity producers. Producers tend to behave more like stocks. During the period of high inflation from 1973 to 1979 and from 1988 to 1991, commodities outpaced inflation. In the period 1980-1984, commodities had a positive return, but did not keep up with inflation.
Real estate: they don’t do anything about it anymore. In each of the three periods of higher inflation over the past 50 years, only real estate investment trusts (REITS) have outperformed inflation. Real estate rents and real estate values tend to rise during times of inflation, which gives a REIT a stable cash flow. REITs can be invested through the REIT itself, or through a fund or ETF. REITs also receive special tax treatment, which can affect after-tax returns in taxable accounts.
Conclusion: Diversify. Whether we are in a period of sticky or slippery inflation (or both), diversification makes sense. Don’t forget to rebalance your portfolio, perhaps shifting some of the weight to small caps, real estate and commodities. Don’t forget the I-bond either: 7.12% on a government bond is damn good. As always, I will try to answer questions: [email protected]