So how’s everyone’s 2022 been so far? It’s only been a month or so into the new year, and already some pretty momentous things have already happened.
At the beginning of the year, there was quite a bit of news to feel crappy about. A new COVID variant of unknown transmissibility and deadliness was rampaging around the world. A push for boosters renewed the mad scramble for vaccines that we thought were a distant memory. And multiple cities (including ours) had re-implemented lockdowns.
What a difference a month makes.
Now, multiple governments all around the world (including up here in Canada) have concluded that while Omicron is still pretty dangerous for the unvaccinated, its deadliness is similar to the flu for the vaccinated. Lockdowns and other restrictions are being rolled back. And countries in Europe like Denmark and the UK have declared the COVID pandemic effectively over and returned back to normal life.
The abolishment of COVID-19 restrictions, which were imposed by the Danish authorities in order to maintain the Coronavirus situation under control, means that travellers are no longer obliged to wear face masks or use the Covid vaccination certificate in order to enter bars, restaurants, and other indoor venues.Denmark Lifts All COVID-19 Travel Restrictions, Becoming First EU Country to Do So
In short, we appear to be exiting this pandemic.
And while there’s still plenty of work to be done by doctors and scientists in mopping up the last gooey remains of this virus, us financial folks can turn our attention to something else: Inflation.
U.S. consumer prices soared last year by the most in nearly four decades, sapping the purchasing power of American families and setting the stage for the Federal Reserve to begin hiking interest rates as soon as March.U.S. Inflation Hits 39-Year High of 7%, Sets Stage for Fed Hike, Bloomberg.com
Yes, inflation is back in a significant way for the first time in nearly 40 years. Seemingly everything’s affected, from gas, to groceries, to housing. This wasn’t entirely unexpected, as printing trillions of dollars in COVID stimulus was bound to do something to the currency. That being said, I’d rather be dealing with inflation amid an economic recovery rather than a complete economic collapse and mass unemployment, so this is most definitely the lesser of two evils.
That being said, we still have to figure out how to position our portfolios in this new environment.
Inflation isn’t something that has a singular solution for, and that’s because inflation isn’t something that has a singular reason for existing. Inflation could happen due to monetary policy, supply side shocks, embargoes, wars, assassinations, and natural disasters. And depending on the cause, the most appropriate response changes. If inflation were happening due to a war, for example, it doesn’t make sense to load up on real estate in that country even though real estate has historically been a good inflation hedge.
So for the record, today’s inflationary environment is caused by two things:
- An oversupply of money caused by COVID stimulus
- Supply side issues caused by worker shortages
Worker shortages are temporary, so that leaves the money oversupply issue. On the plus side, the economy is growing on a real GDP basis and unemployment is really low at just 3.9%, so that means what while inflation may be high now, it will recede as long as the government stops printing money and the economy continues to expand.
So in this scenario, how should investors like us position our portfolios?
Real Return Bonds or TIPS
Real Return bonds are bonds that are structured to pay an interest rate pegged to inflation. In the US, they’re called TIPS, or Treasury Inflation-Protected Securities.
So you’d think that in a high-inflation environment, you’d want to swap out your bonds for these, right? Eh, I’m not convinced about that.
The reason is that because interest rates change with inflation, you have to care not only about the level of inflation but also the future trajectory of that inflation. If inflation is currently low but rising, then TIPS would be a great thing to own, since not only will their interest rate reset higher, but their capital value will go up as well since they’re now much more attractive.
However, if inflation is currently high but going down, then the opposite will happen. Interest rates will reset lower and drag values down. And that’s the situation I think we’re in.
I mean, inflation is high, but the issues that caused it are improving. Governments are no longer printing money like crazy, and labour shortages are improving as COVID recedes. If the opposite were true (i.e. re-surging COVID, more lockdowns, and more money being printed), I might be more tempted to own these, but right now I think TIPS and real return bonds have more downward pressure on them than upwards.
Gold is having a bit of a comeback recently, as it’s the only asset class that’s not currently super volatile.
Stocks have slumped this year. But gold, by comparison, has had a fairly solid start to the year. The price of the yellow metal is roughly unchanged, hovering just below $1,800 an ounce.Gold is shining again as stocks wobble, CNN.com
That being said, I don’t think gold is the right move right now. Gold is what you buy if the economy is in the crapper and the currency is in free-fall. If this were 1920’s Germany and the mark was being treated like toilet paper, I’d be shovelling my money into gold. But we’re not in that situation. The USD is still the world’s reserve currency, and not looking like it’s about to lose that job anytime soon, and again, the economy is growing, not shrinking. I’d give gold a pass.
Hahahaha just kidding.
I check in with the Crypto bros every so often just to see what the crazies are up to, and they are not having a good time right now. The S&P 500 may have gone down 10%, but Bitcoin has fallen by almost 50% over the last few months.
I won’t get into all the reasons why that happened, but suffice it to say that all the arguments that crypto would replace the dollar and act as a hedge against inflation evaporated overnight.
Along with 50% of Bitcoin’s market cap.
Real estate has historically been a good hedge against inflation, but not this time.
The pandemic has given us financial types many surprises over the last two years, but none are as puzzling as its effect on the real estate market. Pandemics are supposed to be bad for housing. After all, who wants to buy a home over a Zoom call?
But instead, real estate shot up, especially up here in Canada. Nationally, we saw real estate values rise by 17%, and here in Toronto it’s up by 31% year-over-year. None of that makes any sense, and the only possible explanation is that cheap interest rates have enticed too many people to get into stupid amounts of debt that they will never be able to repay.
Now that interest rates are rising, the opposite effect should happen, causing housing to rebound back downwards to more normal prices. None of that makes real estate a good idea to get into right now.
That being said, Real Estate Investment Trusts, or REITs, which track commercial real estate like shopping malls should continue to rebound as storefronts reopen and life returns back to normal. And because rents tend to rise with inflation, the current environment will likely be positive for both yields and capital values.
This might be counter-intuitive as the stock markets have taken a beating lately, with the S&P 500 officially entering correction territory last month (defined as a drop of 10% from a recent peak). However, I still think equities is where it’s at.
The business environment is looking really positive for the year. Not only are companies ridiculously profitable, dividends are continuing to get paid and, in some cases, increasing quite dramatically. That’s a very strong indication that companies are flush with cash.
And equities also act as a natural inflation hedge. If you’re getting annoyed that your gas is getting more expensive, that means that the oil company you’re buying it from is making more money. That extra profit becomes reflected in its stock price as well as in dividend increases.
What Are We Doing?
Now again, reminding everyone that these are our opinions only and not financial predictions, which again, nobody can accurately make, are we planning to make any portfolio changes to account for inflation?
In short, we already did. When we sat down to do our 2022 portfolio review and decided on changing our asset allocation at the end of December, the primary reason for increasing our equity allocation to 90% was, again, because the math told us that the dividends were enough to more than cover our living expenses. The second reason was because we knew that inflation would stick around for a while and equities provide a good inflation hedge.
TIPS, gold, and (ugh) crypto don’t make sense for us for the reason outlined above.
REITs might have been more interesting a few years ago when we needed the higher yield, and I might have been tempted to swap out some of my bonds for a REIT index like XRE. But since our current portfolio provides us all the yield we need, why add the added complexity for a yield play if I don’t need it?
So there you have it. That’s my take on the current state of inflation, what we can expect going forward, and how we have positioned our portfolio going forward to weather the inflation storm.
What do you think? Are you doing anything special to protect your investments from inflation? Let’s hear it in the comments below!
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