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Time to Revisit Inflation Risk

| August 25, 2020
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Inflation is one of the most significant risks investor’s face. Even at fairly mild levels, it can destroy purchasing power in very little time.

There are 2 inflationary episodes in ‘recent’ memory that explain a significant portion of the price increases.  The first is WWII, which saw price levels increase throughout the war, and additionally from the public debt accumulated to finance the war. The second is the stagflation (low growth, high inflation, high unemployment) of the 1970’s, which was caused by a combination of external oil shocks and misguided monetary policy. However, inflation has remained relatively low and stable since. 

As the high rates of inflation of those events increasingly become a distant memory, most investors have put the threat of inflation to their portfolios on the back burner.

In the current crisis, it is believed that deflation is the major issue in the short-term due to the massive negative demand shock (a sudden decrease in demand for goods or services). In this case, this is caused by both the threat of the virus and the unknown future direction of the economy, potentially leading to lower investment, weaker consumption, higher savings rates, and slower movement of money across the economy.

So why are we bringing inflation up? We believe that although the threat of inflation is not imminent, it is prudent to consider the potential risks in the medium to long-term as governments across the globe and central banks address the pandemic through massive liquidity injections and unprecedented fiscal and public spending programs. Should the government and central bank continue these programs in order to ‘stimulate’ the economy, there is a very real chance that they overshoot their goals, leading to inflation.

For now, inflation expectations as measured by the 5-yr TIPS breakeven rate have risen from their March lows, but remain well below the Fed’s 2% target and are in no way suggesting an imminent inflation problem.

 

If the risk does begin to increase and investors were to consider proactive ways to hedge the future risk, how could they? We researched which asset classes might be best to allocate towards based on their inflation beta (how much an asset’s return increases when inflation goes up by 1%). The following asset classes most consistently demonstrated inflation-hedging qualities:

  • Treasury Inflation-Protected Securities (TIPS)
    • A U.S. Treasury bond indexed to inflation in order to explicitly protect investors from inflation. TIPS come in three maturities: 5, 10, and 30 years.
  • Commodities: Broad category including grain, precious metals, electricity, oil, beef, etc.
    • Commodities are an indicator of inflation to come. As the price of a commodity rises, so does the price of the products that the commodity is used to produce.
  • Real Estate Investment Trusts (REITs)
    • As inflation rises, so do property values, and so does the amount a landlord can charge for rent, earning higher rental income over time. This helps to keep pace with the rise in inflation.
  • Global Equities/Non-dollar currencies
    • May help combat inflation driven by higher prices for imported goods which are brought about by a weaker U.S. dollar. Certain equities will also be able to pass on higher prices to consumers.
  • Gold
    • Gold is often seen as an "alternative currency," particularly by countries whose currency is losing value. Gold is a real, physical asset, and tends to hold its value for the most part.

It’s important to note that there is no perfect inflation hedge, and the performance of an asset class can vary depending on the underlying causes of inflation.

The truth is that nobody truly knows how this will all unfold because we have never seen anything quite like it. Therefore, a well-constructed portfolio that accounts for an investor’s specific circumstances, goals, and risk tolerances remains best positioned to achieve long-term investment success – regardless of the obstacles. We will continue to research thoughtful, well-diversified approaches to prepare portfolios for whatever lies ahead. 

Dustin Dorhout

WealthPLANPartners

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.  To determine which Investment(s) may be appropriate for you, consult your financial advisor prior to investing.  Information is based on sources believed to be reliable, however, their accuracy or completeness cannot be guaranteed. Statements of forecast and trends are for informational purposes and are not guaranteed to occur in the future.

All indices are unmanaged and may not be invested into directly. Advisory services offered through Feltz WealthPLAN, DBA of WealthPLAN Partners.  Securities offered through Securities America, Inc., Member FINRA/SIPC. Feltz WealthPLAN and Securities America are separate entities.

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