Inflation rose by seven percent in 2021, the largest increase since 1981. Not only was inflation high last year, it could remain elevated in 2022 and beyond. The messaging from Federal Reserve Chairman, Jerome Powell, and Secretary of the Treasury, Janet Yellen, has shifted dramatically from “inflation is transitory” to saying inflation will linger.
It’s hard to “profit” from inflation—higher prices are a silent killer for everyone. But how can you structure your finances to better protect yourself from inflation?
What is causing today’s inflation?
Inflation is an increase in prices. As a result, your dollars are worth less as their purchasing power is eroded over time.
Famed economist Milton Friedman said, “Inflation is always and everywhere a monetary phenomenon.” He reasoned that a rise in prices has always been preceded by a rise in the supply of money.
What about today? Government officials have been arguing that today’s inflation is a result of supply chain glitches caused by economic shutdowns. Once they ease, they contend, prices will go back to normal.
Today’s inflation has been stickier than they anticipated. Supply chain issues have been getting better, but prices have continued to rise. If Milton Friedman was right, today’s inflation should have been a result of a rise in the supply of money. So what do we find?
Looking at the M2 Money Supply, which is a good measure of how much money is “in the system” we saw an historic increase starting in March 2020.
Since the pandemic, the money supply has increased by approximately 40%, or close to a 19% annualized increase. Compare that with an average six percent annual rate of growth during the “easy money” period after the Great Financial Crisis.
The difference between then and now is what the government is doing with the money. After 2008, most money was kept in banks as reserve assets. It didn’t “find its way” into the economy to really affect money supply. Earlier in the pandemic, checks were being sent to individuals and businesses. This has increased savings and kept consumer demand strong as the economy continues to open back up.
Will inflation persist? According to this economic theory, we can continue to see persistent inflation, even after supply chain issues are corrected.
How to add inflation protection to your finances
If we are in a period of persistent inflation, what are ways to better protect yourself and take advantage of inflationary pressures?
We don’t know how things will unfold. We can look back to our country’s last inflationary period, the 1970’s, to offer clues. But there are always other factors in play then and now that can cause different outcomes. With this being said, this is meant to be informational and not taken as advice for your personal situation.
Let’s dive in!
1. Be a homeowner with a 30-year mortgage.
An underappreciated way to benefit from inflation is to be a debtor. During the 1970’s, for example, student loans got essentially wiped out as their rates were fixed while incomes were rising at a fast pace.
The same concept is true with other fixed rate debt. Surging inflation is accompanied by higher wages. If you borrowed money at a fixed rate (like a mortgage), your monthly payments will not change over the life of the loan. However, your income will continue to rise. As a result, that monthly payment becomes a smaller and smaller percentage of your income.
This is especially true in today’s market environment. “Unprecedented” is a word that can describe what has been going on.
Source: Ben Carlson
In the past two years inflation has soared and interest rates have been slow to react. Typically, interest rates go up when inflation is anticipated. Who would want to own a 30-year bond that pays two percent when inflation is at seven percent? This guaranteed loss after inflation means people will sell their bonds, making long-term interest rates go up.
While mortgage rates have started to creep up, they are still low (in the 3.5% range at time of writing). Locking in the ability to borrow money for 30-years at this rate when inflation is anticipated to be high is a way to “profit” during an inflationary period.
Not only can you borrow money today and pay it back with devalued money in the future, but you also own a house. Real estate historically has kept up with and exceeded the rate of inflation.
2. Don’t keep too much in cash and bonds.
From a return perspective, some of the worst assets to own during inflationary periods are cash and long-term bonds. When evaluating the rate of return on an asset, you need to look at the real return, meaning the return after inflation.
For the money you keep in the bank, your nominal return is the yield the bank gives you. At time of writing, the average yield is under 0.10%. If you keep a lot of money in the bank, this low rate probably bothers you, but at least you’re not losing money, right?
While your nominal return is positive, your real return is negative. For 2021, your real return was close to negative seven percent. Though you didn’t see a negative number on your statement, the purchasing power of your cash is now 93% of what it was a year ago.
Similarly, long-term bonds can have positive nominal returns over a period while having a negative real return. Bonds are especially prone to bad performance during inflationary periods. Because these bonds’ coupon payments are fixed, you are locking in a particular return regardless of where inflation goes.
If you buy a long-term bond that pays two percent, what happens to your return when inflation is at seven percent? Again, you still get your two percent, but you are losing five percent to inflation.
As this chart shows, the inflationary period of the 1970’s wasn’t friendly for US Treasury Bonds. The real return (after inflation) was a whopping -38%.
Cash and bonds still have a place in an investment portfolio and financial plan. I’m not suggesting that you discard them. But having too much in these assets will guarantee a negative real return and subsequent loss of purchasing power.
3. Invest in stocks and real assets.
How do you maintain and increase your purchasing power when inflation is running hot?
For starters, investing in stocks and real assets has been a positive way to increase the value of your dollars.
First, stocks provide ownership of businesses. A business is not immune to the negative effects of inflation, but many businesses can increase prices to offset the higher costs and wage increases they experience. If consumer demand remains strong, many businesses will see increased earnings that keep up with inflation. This, in turn, can benefit their stock prices and dividends.
Some stocks do better than others. Inflation-sensitive sectors like energy can outperform if the price of oil rises alongside core inflation. The demand for oil and gas is inelastic, meaning that demand is not affected much when there is a change in price. Though people will complain about the price at the pump, their driving habits likely won’t change.
Other sectors that could benefit from higher inflation include companies in the materials sector (construction materials, chemicals, mining, etc.), industrial companies, and financial companies.
Second, real assets can provide a hedge against higher inflation. Real assets are physical assets such as real estate, natural resources, and other commodities. Many of these can be invested in through financial products like real estate investment trusts and mutual funds that invest in commodity futures. Because the value of real assets tends to rise with inflation, commodities can provide outsized returns during inflationary periods.
History doesn’t always repeat itself
It is said that history doesn’t always repeat itself, but it often rhymes. In an investment context, this means there is no investment strategy that will guarantee a return because of inflation.
Who would have thought that in 2021 we would see the highest inflation since 1981, yet the price of gold would finish with negative performance for the year?
The important thing is for an investment strategy to be diversified and able to withstand various market scenarios, including inflation. During the past ten years we witnessed falling interest rates and low inflation. What if the next ten years is marked by rising rates and persistent inflation? Don’t expect the same things that outperformed last decade to lead in the next.