After a long period of calm, inflation is expected to rise in the months and quarters ahead. This spells very bad news for consumers because when inflation is high, they will need to more money to buy the same basket of goods; in other words, inflation erodes people’s purchasing power. This should send negative signals to an economy that depends so much on consumption, given that Canadian households are on pretty much tight purse strings as things currently stand. While many mainstream economists will argue that inflation is a consequence of an economy growing or otherwise performing well – particularly those who believe they would benefit from high inflationary economic scenarios; those in Financial’s and Real Estate to be specific, have it entirely wrong about inflation.
Here are some basics about inflation. What these mainstream economists and investors tend to look at is the so called “headline” inflation. This statistic would exclude so called volatile items such as food and energy. So to most people, the headline consumer price index seems pretty tame. This where they got it wrong, because core inflation does matter to an economy. Think about it; if we have yearly double-digit percentage price increases in food, energy and drug prices, it will weigh down the economy in one way or another. Whether that means consumers will chose to dine-out less often, or a businesses production and transportation costs increase to the point of eroding their investor margins or that increased cost is passed on to consumers, or as we have recently seen, the impact of these increased costs has led to a major insurer shedding jobs, inflation is going to have an impact on the economy, and none of it is good.
If that doesn’t have you convinced, think about everything both the core and headline inflation Government statistics do not track. For instance, I recently booked a flight with an airline I have been flying with for well over 15 years. I was shocked to discover some fee’s that were never there before. In addition to the ticket price, the taxes, and the extra luggage fee, I now have to pay for a seat assignment whether I want to or not. Even a middle seat at the back of the plane carried an extra fee. I can tell you for a fact, that fee was not there 12 months ago. Well, the CPI does not track that expense. Trust me when I am telling you, inflation is here and it is much higher than it is being reported.
As an investor, you should be gravely concerned about inflation because if you have been following the mainstream mantra of growth over value, your portfolio will be very likely impacted by high inflation. Here is what you can do to hedge your savings against inflation.
Beware Long Term Bonds and Real Estate
This might sound counter-intuitive, but both Corporate and Government bonds are terrible investments during times where inflation is rising. Even the so called “TIPS” – that is an inflation protected security, as the inflation is measured by the CPI. If as a metric, the CPI is deliberately omitting volatile items, or is measuring inflation incorrectly, or is simply ignoring new costs such as additional costs to plane tickets, then you are guaranteed to find yourself behind the inflation curve by investing any money in such securities. In a similar fashion, Government or Corporate long-term bonds would keep you locked in to a return that may fall behind the inflation curve. Would you really get ahead with a bond that pays 2% over a five-year period if inflation during that time averages 3%? Ideally, you want to remain flexible to avoid getting caught in inflation’s vice. If you really want exposure to bonds, consider purchasing 30 day bonds from multiple issuers (by issuers, I am referring to nations) – that way you have the security of a bond and exposure to multiple currencies.
As far as real-estate is concerned, although conventional wisdom would suggest inflation is kind to real-estate asset prices, we must consider the uncharted waters we find ourselves in. Here at home and around the world, Central Banks are “unwinding” or halting their asset purchases and rising interest rates, there’s a big risk here for real-estate given the sector’s sensitivity to interest rates. If inflation is rising, you can expect interest rates to rise in kind. We recently discussed the gathering clouds around Canada’s housing market on the RBL blog and the impact rising interest rates are going to have on the housing market.
Inflation Is Good For Commodities
More often than not, commodities is usually an excellent investment response to inflation. Oil is actually the ultimate asset and many a time sees its greatest price appreciation during periods of high inflation. In addition to oil, natural resources such as timber, coal, and base metals tend to rise in price with inflation, given that it will take more dollars to purchase the same quantity of resources. Investors can purchase commodities through a number of exchange-traded funds however keep in mind commodities are a very volatile investment. If you are nervous (like I am) about how commodities will perform in an environment of rising inflation but deteriorating economic activity, then it would be best to consult an experienced and reputable fund manager who is able to monitor your assets performance vigorously. If you chose to ignore oil or other natural resources entirely, you still have options. Cotton, orange juice, coffee and soy beans tend to shine with inflation.
Buying The Right Stocks
Over periods of inflation, certain business sectors perform better than others. That’s why it’s important to add the right mix of equities to your portfolio to offset the impact of inflation. This would include stocks for materials companies, industrial companies, agricultural companies and transportation companies as they all stand to gain from higher selling prices. You might also want to broaden your horizon and take a closer look at international companies in emerging markets. Generally speaking, they have better exposure to these sectors than Canadian stocks as well as lower production costs. When it comes to inflation and rising costs, the equities that will perform the best are those with lower production costs and higher margins. Speaking of lower costs, you can take a look at small-cap stocks. Although they carry greater risks than their large-cap counter-parts, they tend to be much leaner so higher selling prices could deliver a greater earnings leverage.
An old and tried and tested favourite, as the value of currency deteriorates, precious metals hold their value. Gold and Silver can be purchased directly from the Royal Canadian Mint and kept at your home in a safe, or in a safety deposit box, or, can be purchased through an ETF that holds precious metals. We wrote about the benefits of adding Gold to your portfolio in our blog recently. Finally, if you are thinking about individual gold or silver mining stocks, in kind with what was discussed above, consider purchasing stocks with low costs, or companies with disciplined costs.
Oil prices in Canada have recently hit an all-time high, while the cost of living is soaring. Inflation is very real and in my opinion, there is only one direction it is heading and that is up. Any measure you can take to prepare for inflation will payoff handsomely, both as a hedge against your current safe-nest and in the long run. As always, there is no single defence against inflation but hopefully these strategies provided you with some food for thought. Even if inflation remains “tame”, having exposure to some of the asset classes discussed above will do your portfolio no harm. But if you haven’t thought about how inflation will impact your portfolio, now is the time to act and diversify your investments.
The opinions expressed in this article are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security or investment product. I am a not financial advisor and I do recommend you consult with a financial professional before making any serious financial decisions.