Investing During High Inflation

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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:

  1. An oversupply of money caused by COVID stimulus
  2. 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

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.

Cryptocurrency

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

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.

Equities

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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25 thoughts on “Investing During High Inflation”

  1. Interesting perspective on the real estate. I’m looking to buy a vacation home in the White Mountains of New Hampshire. But the prices have gone through the roof (increased by maybe 50% since before the pandemic). Places that hit the market just get snapped up with hours, or days at the most… evidently people are touring the homes over zoom or facetime and submitting aggressive offers. I think it has to do with people being able to work remotely, coupled with low financing rates. I wonder if the prices will ever go down again? Or is this the “new normal”?

  2. “Why add complexity?” HECK YEAH. Thoreau and da Vinci had it right about keeping things simple.

    I agree with Captain Cactus there about real estate. Redfin thinks our little century-old bungalow, with just one bathroom and in a not-great school district, is worth $499,751. That’s almost half a million dollars of actual USA money. Utterly insane. I want nothing to do with that game beyond living in one (1) house that we could afford eleven years ago.

  3. How to invest during high inflation?

    ——

    Index-fund investing. (Isn’t that always the answer?)

    In Re REIT, I’m not sure what is the difference between that and equity these days. They pretty much march in lockstep. The dividend yield for something like VNQ is also relatively low (~2.7%), used to be around 4%.

    Why bother with REIT at all? I wish you would write a post on that.

    1. I would argue that REITs offer additional diversification of one more asset class. They are required to pay a certain percentage of profits as dividends, so REITs tend to have higher divvy payouts. I keep my allocation below 3% and enjoy the monthly income.

  4. I have to disagree somewhat with your point on Real Estate. Yes in Canada the market is very warped but here in the United Kingdom in England property prices are slowly continuing up and the rental market has limited supply of stock and rental prices are also going up therefore offsetting any inflation. I myself am purchasing more real estate in the England, especially as it comes with a 15 to 20% cash on cash return and that’s even before appreciation

  5. Here’s some food for thought….Mortgage rates were around 6% back in 2006 (just before the housing crash). Rates are currently around 3%. Given the existing outrageously high real estate, I’m wondering if the real estate market could even sustain itself if rates started tickling the 2006 rates. We might even start to see trouble if rates go above 4%.

  6. I’m trying to buy a condo in Toronto. In 2021, with $750k I could afford a 2bdrm condo. In 2022, I’m priced out and can only afford a 1 1.
    Buying a condo will essential make me house poor.
    I don’t know if condo prices will ever come down bc lots of ppl working from home have extra cash saved up and immigrants coming soon- I suspect housing prices will continue to rise…

  7. I really like the investment thesis for Fundrise for two reasons: first, they have idiot proofed it. If the market tanks, they stop redemptions to prevent panic selling which would force them to sell properties at a loss. Second, they invest in nice but not luxury apartments, built as rental home communities and last mile “amazonish” warehouses. Where do people go when the economy tanks and they loss their house? Apartments – so their dividends are counter correlated to the stock market and we use this to generate income for most of our living expenses.

    Our “spending money” is in Vanguard TIPS just because it’s the only stable and safe investment that is actually almost keeping up with inflation. I agree that they don’t have a rosy future but neither does anything else except stocks, and I don’t want that kind of volatility on money we need to spend today.

    Savings account interest rates and security are a joke – who is backing the FDIC? The US Government – the same entity that backs TIPS but they pay 5% and savings accounts pay essentially nothing.

    1. I really like the investment thesis for Fundrise for two reasons: first, they have idiot proofed it. If the market tanks, they stop redemptions to prevent panic selling which would force them to sell properties at a loss.

      ———

      Why, yes! Why wouldn’t I invest in something that could arbitrarily stop redemptions? That’s every investors wet dream. Not!

      I really DO NOT LIKE their investment thesis. Only fools invest in garbage like that.

  8. JMO: A stock market correction along these lines is typical in the 2nd year of a first-term U.S. presidency with a mid-term election this November. “We’ve been here before.” Corrections along these lines take place either at the beginning of the year or after the mid-terms. After 3 consecutive years of 20%-plus returns in U.S. equities (for the first time since 1997, 1998 and 1999), we can keep this correction in perspective. Of course, your mileage may vary.

  9. Agree with Wes… sadly. Here’s the latest US GDP estimate from the Atlanta Fed: 0.1% for Q1. Hold on tight, it’s going to be a bumpy ride…

  10. My humble opinion on the reaction to a “this time it’s different” view and the shift to 90% equities for inflation purposes is be careful this isn’t just market timing in disguise. It may be the right move but it should be worrying when anything like this can be cause for changing your asset allocation.

    Otherwise, what’s the plan if equities crash 40% and there’s deflation again? do you plan to change asset allocation back down from 90% and sell equities low? the numbers then would also suggest you need to sell equities for a yield shield again.

    there would be endless readjustments to “the moment” which is precisely what the asset allocation is supposed to shield you from such fickleness

    1. put another way, if inflation is highly correlated to stock market (which is why you called it a hedge). then readjusting to more equities when inflation is high is simply buying more equities when they’re high using its proxy indicator. the approach sets you up for bad market timing, buying high selling low.

  11. Still very much in the learning phase here but wondering, what happened to the preferred shares as an alternative to bonds in a rising interest rate environment?

    From your post “WILL RUNAWAY INFLATION DERAIL THE RECOVERY?” on June 21, 2021:

    “I’ve moved our Portfolio B fixed income allocation to Preferred Shares (ZPR) and our Portfolio A fixed income to a Short-Duration Bond Index ETF (ZSB).”

    However, here you say you’ve only moved to a 90/10 asset split. Have I missed something? Or does that 90% include preferreds and the 10% is the short-duration bonds?

    Thanks!

    1. You’re asking good questions, Jamie. There was a time our hosts were clear and transparent. That has changed. New readers who would review the investment series would be led to believe that investing 40% of their portfolio into VAB would be a good thing to do. That is a very bad thing to do at this point. People should hold fixed income in their portfolio and at this point, it should be (in Canada) a mix of rate reset preferred shares like ZPR or DXP, short term bonds like VSB, and potentially floating rate debt like MFT. When rates have peaked, by all means convert all of that to VAB but at this time, VAB is a serious problem.

      There’s 2 things I always seek in my portfolio:

      1: consistent and steady growth.
      2: consistent and steady income from it.

      You cannot achieve this by being lazy or not having a sense of high level market movement (at the layman level – nothing more sophisticated).

      What Kristy and Bryce advocate for themselves is not wrong (for them). What’s wrong is that most investors can’t handle that. VFV is currently down in 2022 by -6.73%. Most people will shit their pants holding 90% of that in their portfolio and only 10% in fixed income. Most will lie and say it doesn’t bother them but let’s get real, it bothers them. It would bother me. Now, if they held VAB as their 10% fixed income component which had a 2022 return of -2.97%, that would bother many further.

      Jamie, like I said, you asked good questions. Your gut is telling you something and you should pay attention to it as you have. I learned a lot from Kristy and Bryce. So much so that I can confidently hold up the other side of the argument and see where things don’t make sense anymore. It’s also why my portfolio isn’t running negative for 2022. I do appreciate that they let us publish our views and hopefully through that, we can all come to more informed and complete decision making.

    2. They made the change in 2021 and updated recently in the annual portfolio review. This was necessary since interest rates on bonds were too low. There was no advantage to invest in bonds.

      Short-Duration bonds is an equivalent of cash, although you may be able to get a little more interests on the investment.

      Personally, I never invested in preferred shares, and I don’t recommend them for new investors. They are a specialized type of investments. It’s possible to make money out of them. But they have the double handicap of being neither a bond, nor a share in equity.

      In other word, their income is not guaranteed (the company can decide to stop the dividend if they want) and there is no potential increase in value like it is possible to get with ordinary shares since their dividend is fixed in advance.

      They may seem attractive in a low yield environment like the one we have right now. But they are generally a bad investment. I think this is the reason why there are so few of them.

      There are exceptions where you can make a lot of money with preferred shares, like when you buy at a very low price or when a company issue shares during time of financial stress. But I think it is better to let those opportunities to specialized investors…

  12. Personally, I don’t see inflation diminishing any time soon. In fact, I think inflation will even accelerate.

    Usually, to reduce inflation, we would need to have interest rates above the inflation rate. Otherwise, it’s better to borrow (or sell bonds) at a lower rate and buy physical goods that are increasing in price at a higher rate (houses, cars, furnitures, etc).

    Obviously, this is theoretical. In practice, knowing which item to buy just before it goes up in price is much harder to do. But if the inflation reach 10% or more, then it becomes much easier to do.

    My portfolio is still mostly in equities – particularly in value stocks. I also use leverage (around 18%) to take advantage of inflation (since the debt get devalued with inflation).

    Gold and REITs are still small portions of my portfolio.

    Gold is new for me. I’ve started investing in gold in 2020 and 2021. It is now 6% of my portfolio. It is invested in the biggest and highest quality gold companies in the world (Barrick Gold, Newmont, Wheaton, Franco-Nevada, Agnico-Eagle).

    My REIT investment is Riocan (best Canadian REIT imo). It is now 3.3% of my portfolio – up from 1.4% before the pandemic.

    My two biggest investments are related to oil: Couche-Tard (6.2%) and Suncor (6.0%).

    If we really have inflation, oil will be one of the commodity that have the most impact on our life, since it is part of the cost of almost everything we consume, from airline travel to food transportation and every piece of plastic that we take for granted today.

    Like you said, as the price of everything goes up, I expect to be on the receiving side as well as a shareholder of many different companies.

    I still wish inflation to be contained – for the better of our society. But we have to be realistic. This may be a major problem going forward.

  13. As a Canadian can I buy TIPS? Or a CDN equivalent? I can’t seem to find the answer online. We don’t seem to have an equivalent in Canada. Oh to be able to buy our savings bonds in the day when the return was 18%!

  14. This all sounds too much like market timing to me. The long-term winning strategy is to choose an appropriate Asset Allocation for your personal risk tolerance and stick to it. It is the *best* tool for managing your risk. And when the market goes on a tear (personally I use a 5 point move in my AA) you *rebalance* back to your desired/defined AA. That results in you selling when equities are high. Conversely, when the market tanks you *rebalance* back to your desired/defined AA which results in you moving *into* equities when they are down. It results in the highly desirable behavior of buying low and selling high, but with the caveat that you make these moves *after* the market has moved, not in anticipation of what you think the market *might* do in the future (ie market timing). This results in a much more sane reaction to market volatility.

    1. Risk tolerance can also change over time, however. For example, if you retired 10 years ago with $1m and now you have $2m, but your spending hasn’t doubled, you’re more able to weather a downturn allowing for a higher risk profile.

  15. Meanwhile in Turkey! That’s some serious inflation.

    Housing is crazy over here in Australia over the last few years, with cheap interest rates allowing more and more debt.

  16. Your have got some wonderful investment outlook there. I know the real estate market of Canada is so hot right now. It seems nuts to try and buy a house today. but , also if it will come down again. I hope it does. With free money floating in the market, all the investment options seem highly volatile except gold. I would suggest anyone to make investment with good amount of caution rather than money.

  17. I laughed at cryptocurrency for years and I regret it now every day. I could have put $100 into shiba inu when it first started and now I would have had 45 million dollars. same thing with missing out on bitcoin, ethereum , dogecoin ect. I laughed at cryptocurrency as a scam or pyramid scheme and it cost me retiring early as a millionaire.

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