How to successfully hedge against inflation.

How to protect your portfolio from inflation with different asset classes. With talks of inflation roaming, FlowBank explores some ways investors could diversify away inflation risk.

Key takeways

  • Rising bond yields, producer prices, and an impending stimulus bill could signal inflation ahead.

  • In an inflationary scenario, cash is trash and bonds and CDs depreciate.

  • Hedging through an ETF is a solution; think IVOL or INFL.

  • Ways to hedge include real assets, value and energy stocks, commodities, and... lawn mowers

  • Labor costs increases can affect bottom lines, and Walmart’s $15 minimum wage.

Why does inflation matter?
What is most penalized by inflation? Sitting cash like funds in checkings and savings accounts and fixed income products like traditional bonds and CDs. Bonds lose value with inflation because of its inverse relationship to rates. Simply put, the worth of a bond today, is related to rates in such a way that when rates rise (when there is inflation) the worth falls. For cash, the reason is even more simple in that your purchasing power simply shrinks as goods become relatively more expensive. You will buy less of a good you bought yesterday when its price rises tomorrow. A lot of people are unaware of this and tend to hold their cash in savings in fear of changing market moods—wrong move. Savings offer poor interest rates, and cash is trash in an inflationary scenario, but fear as there are ways to protect your assets:

The basic solutions...
In an inflationary scenario seeing 3% to 5%, the best assets to buy are usually commodities, Treasury inflation-protected securities (TIPS), energy and materials stocks, and industrial metals. Stocks in high growth companies or consumer good companies tend to see increased profits from inflationary settings. Good move. Commodities, things like crops and raw materials are considered good hedges because their prices go up when prices of other good and services that use those goods as inputs also go up. Oil is an example, copper is another.

Real assets and intrinsic value...
Real assets count too. With real estate, prices naturally rise with inflation which is a good thing. When land becomes more expensive for example, so too do houses and apartments. One may turn to REITs to invest in real estate as an alternative to buying an apartment or house, they tend to perform during inflationary scenarios. Much like cigarettes in prison of war camps, real things, tangible things one can touch and derive intrinsic value from, usually are more liquid and protected against market shocks like inflation.

Sales matter...
As mentioned previously, firms that can wring profits from higher prices will look more favorable for your portfolio. Companies equipped to derive earnings from sales quickly are go to investments think automakers, mining and refineries, and fertilizer producers. In seven out of nine cases of high inflation since 1972, energy stocks have had the best track records against rising consumer prices, outperforming the S&P 500 by a median of 14%. Furthermore, cyclical value stocks whose sales are more sensitive to economic swings tend to perform well during inflation scenarios. Energy stock examples include Exxon, and Marathon Oil Corp whose surging prices at the start of the year serve as a testimony to that phenomenon.

Operating leverages and labor costs...
Another way to put it is that investors will be looking under the hood for firms with high operating leverages, those firm that can extract relatively more profit out of every increasing dollar of sales. One caveat however is regarding labor costs, which Walmart has entertained the thought of with a $15 minimum wage act. Labor costs could increase on wage growth likely accounting for a 1% reduction in firm profits overall. Biogen and Under Armor are example of such firms whose labor costs make up a smaller share of revenue and would thus not be burdened to the extent Walmart might. In the defense of Walmart, the firm has seen sales increase enough to potentially justify a break even from increased wages, with analysts tracing this earnings increase from government stimulus checks.

Inflation killing ETF...
The Quadratic Interest Rate Volatility and Inflation Hedge ETF (IVOL), launched in 2019, makes use of TIPS and interest rate derivatives in swaps to hedge inflation and is run by Nancy Davis, a top 100 influential woman in finance. Newer still from January, is the Horizon Kinetics Inflation Beneficiaries (INFL) which concentrates on shares the managers assume will profit from inflation. IVOL provides fixed income choices to counter a longer period danger particularly ones based on the treasury yield curve. The outcomes of Davis’ strategy so far have been strong with IVOL showing 18.17% annual returns in 2020. INFL, eschews TIPS and commodity futures that favor equities. The fund emphasizes corporations that are capital light like Franco-Nevada who own a portfolio of royalties in gold mines, VanEck Vector Gold Miners, and CME group who is a beneficiary of rising inflation. Overall, both funds are supposed to complement your current portfolio.

A looming threat of inflation?
Government spending, and the torrent of liquidity unleashed by central banks to combat the pandemic’s economic wrongdoings suggest inflation ahead. The IMF has forecasted an average annual inflation rate in advanced economies of 1.6% (doubling YoY) in 2021 with some estimates as high as 2.3% from Citigroup. Commodity markets soaring could also suggest inflationary pressures with Brent crude rising from $20 to $60 a barrel, with some estimates suggesting a $100 scenario being possible. Copper, and Platinum showcase the same trend. The large stimulus packages expected in the United States have been priced in by investors and has led to the yield on the 10-year treasury rising to 1.3% (up from 0.72%).

Probably just reflation...
The Wall Street Journal suggests that looking at consumer prices as a signal for inflation might be the wrong approach, that consumer prices barely budged during crises such as the tech bubble and housing price bubble and that therefore one ought to look at asset prices instead. We know that Tesla is up more than 300%, copper prices up 56%, the Case-Shiller home price index is up 9.5%, freight prices are up 215%, soybeans 54% and lumber 117%. Are these flagrant flags of inflation? Powell says otherwise. Housing prices are simply reacting to folks adapting to the pandemic and moving more freely across the country. Nancy Davis of Quadratic Capital says that in swap markets (where firms can hedge for inflation) firms are pricing inflation in the two-to-ten- year horizon at 1% a year and that so far inflation threats do not take center stage.

Brief conclusion...
So, you want to hedge against inflation? Forget cash, toss bonds and ignore CDs for now. Real assets rise with inflation, good plan. Can’t afford it? Look at REITs. ETF like INFL and IVOL managed by top asset managers? Why not. Scoping out financial statements? Look for low labor costs as a percentage of revenues, and look at high operating leverages. Earnings are key; find firms that can increase their figures when prices rise. Inelastic demand markets fit that description well. Cyclical value stocks, commodities, energy equities, materials, and TIPS, all yours to think about.

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