In this article I discuss the merits and detriments of investing in the major asset classes when there is inflation. In my mind there is little doubt that inflation is a serious issue. According to John Williams of ShadowStats, inflation as calculated without hedonic adjustments or substitution bias is somewhere in the high single digits.
Given this data along with the fact that the Federal Reserve is expanding its balance sheet at a rate of $85 billion per month, a successful investment strategy must take inflation into consideration.
1--Some Math for Investing in an Inflationary Environment
Investing in an inflationary environment is like trying to climb an escalator that is going down while some idiot is pulling on your shirt from behind. In order to preserve your assets, you not only have to manufacture enough nominal gains (climb the escalator as it goes down) to retain your purchasing power, but you have to do so in an environment in which the government (the idiot grabbing your shirt) recognizes your nominal gains as real gains and taxes them accordingly.
Suppose that inflation is 10% per year. I make this assumption for the sake of mathematical simplicity, although given John Williams' inflation data this is a realistic assumption, and it may turn out to be conservative. Let's say that you have $100, the purchasing power of which you want to preserve. Since next year your $100 will be worth $90 in this year's money, you need to earn the equivalent of $10 on $90, or 11 1/9% on your money. Hence you must make at least $11.12 (rounding up) just to break even before taxes. If you take profits every year and pay a 20% capital gains tax then you must make an amount, $x, such that (1-0.2) * $x = $11.12, or $13.90 (13.9%).
Investing is more tax efficient if you take capital gains less often, yet this observation assumes that the capital gains tax remains the same. If you take capital gains after 2 years instead of after one year you have to make $19 on $81, which is 13.73% per year before you pay taxes. Generally if you take capital gains after n years you have to make the equivalent of $(100-x) on $x, where $x = $(100 * (1-0.1)n), or [(($100/$x)-1)/(1-0.2)]%, where 0.1 (10%) is your inflation rate and 0.2 (20%) is your tax rate. To annualize this rate simply add 1 and take the nth root (the number to the right of the decimal is your annualized break-even rate).
It is clear from these calculations that if investors are to succeed in an inflationary environment that they must aim to achieve returns that exceed their inflation expectations.
2--Analyzing Specific Asset Classes
What follows is an analysis of the major asset classes as investments in an inflationary environment.
Commodities are probably the best investments in an inflationary environment. This is because while the dollar loses value as a result of quantitative easing and credit expansion, the supply of commodities cannot be inflated. Commodities must be produced and this production requires labor and energy. Furthermore no matter how much labor and energy goes into commodity production there is a limit to the amount of commodities that can be produced.
A1--Direct Commodity Investments
For investors who expect inflation direct exposure to commodities is the most intuitive investment strategy: assuming that there are no changes in the supply and demand of a given commodity, and no change in the demand for the monetary unit in which the commodity is priced, the price of the commodity should increase proportionally to the rate of inflation. However the supply and demand for individual commodities is dynamic, as is the demand for money and credit. Thus if oil costs $100/barrel this year and inflation is 10% then it is feasible that next year oil might cost $103/barrel, or $125/barrel, or $90/barrel.
In order to achieve the gains needed to combat inflation commodity investors need to consider the following.
First, like with any asset, investors should analyze the longer-term supply-demand fundamentals of individual commodities. While commodities have performed extremely well in the 21st century as evidenced by broad indexes such as the Reuters Continuous Commodity Index, investors would have substantially outperformed such indexes by emphasizing commodities with better supply-demand fundamentals, such as silver, and de-emphasizing commodities with unfavorable supply-demand fundamentals, such as natural gas.
Second, investors must consider the practicality of investing in commodities. Commodities are the most intuitive investments in an environment of rising prices, but benefiting from their price appreciation is not at all intuitive. Commodities need to be stored, and this has different implications for different commodities. For example you can hold $1,000 of gold in the palm of your hand, but $1,000 worth of sugar weighs more than a car. Thus the durability and ease of storage of commodities may factor into their demand fundamentals as investors seek to purchase assets that protect them from inflation.
These practical considerations greatly impact the performance of commodity investments. Take the USO as an example. The USO is an ETF that holds oil futures and is supposed to give investors exposure to the price of oil. It has declined since its inception in 2006, yet the price of oil itself has risen. This is because the oil futures held by USO have to be "rolled over;" that is, when the contracts are about to expire the fund has to sell them in order to purchase contracts that expire further out into the future. Because oil is subject to costly storage the contracts that expire further out into the future are often more expensive than those that expire sooner (a phenomenon known as contango). Furthermore, when the fund rolls over its futures contracts it incurs trading commissions. Consequently the amount of oil represented by a share of USO declines over time, and the divergence between the current spot price of oil and the value of USO shares becomes increasingly punitive to USO shareholders. While there are exchange traded products that have been developed to combat this phenomenon they often do so with minimal success.
With this second consideration in mind, investments in durable commodities with high value to weight ratios have a natural advantage over those that lack these qualities. The following table outlines investment opportunities in durable, high value to weight commodities. These are not investment recommendations, and there may be other supply/demand considerations outside of their high value to weight ratios that might make them poor investments.
|Gold||Gold investors should favor PHYS over GLD given that PHYS is taxed at the capital gains rate while GLD is taxed as a collectible. I discuss this in greater detail in my article: Buying and Owning Gold Part 2.|
|Silver||As with gold, silver investors should favor PSLV over SLV for the same reason. I discuss this in greater detail in my article: Buying and Owning Silver Part 2.|
|Platinum and Palladium||Investors should consider PLTM, PALL, and SPPP.|
|Investment Grade Precious Stones, Artwork, Rare Collectibles||Investors require highly specialized knowledge, which I lack, in order to invest in these items.|
|Heavy Rare Earth Elements||Investors should consider purchasing shares in DCHAF.PK, which is a holding company focused on storing heavy rare earth elements.|
Uranium has a lower value to weight ratio than the other investments listed here, however investors have access to shares of URPTF.PK, which holds physical uranium based compounds with minimal storage fees, and so I include it in my list of high value to weight investments
Other commodities are far more burdensome and costly to hold and so related funds should generally be avoided except where investors have extremely high conviction in their value. Even so, investors should first consider purchasing shares in companies that may benefit from their appreciation.
Given that investments in commodities come with added costs investors should consider buying the stocks of companies that benefit from rising commodity prices.
However there are other considerations associated with owning commodity stocks. First, supposing that one is bullish on commodity prices one might purchase shares in companies that are involved in their production that may not see the benefits of their appreciation. For example, Alico (ALCO) holds and manages farmland. If they experience a drought the shares will likely suffer while simultaneously the commodities that Alico produces might benefit from the supply shortage created by this very drought.
Second, investors must differentiate between companies that own commodities in the ground or land that may contain commodities, and companies that service the first kind of company. Suppose a company such as Apache (APA) is exploring for oil or natural gas and they hire Halliburton (HAL) to drill for them. Halliburton will make money regardless of whether they find anything. Yet if they do find something it is likely that Apache will be the larger beneficiary. Also consider that Apache and Exxon Mobil (XOM) do not compete with one another on price. Yet Halliburton must compete with Schlumberger (SLB) for drilling contracts. While it is true that if oil and gas prices appreciate then both HAL and SLB can likely raise their prices the two companies must still compete on price and quality of service.
Third, while rising commodity prices act as a tailwind for commodity producing companies, these companies face inflation headwinds like any other. For example if oil and steel prices appreciate faster than copper prices, then a copper producing company such as Southern Copper (SCCO) may suffer even if copper prices rise because they use oil-fueled machines built with steel to extract and ship their copper. Thus investors must consider the relative value of the commodity a company produces vis-a-vis the value of their commodity inputs.
Given these considerations and risks, commodity companies that are chosen wisely will function as good inflation hedges, and they may offer substantial real (inflation adjusted) returns to investors.
Except for the most distressed bonds that are chosen wisely there is little to no opportunity in the bond market. First, bond income is treated as ordinary income, which is taxed at a higher rate than long-term capital gains. Thus the nominal returns that one must achieve in bond investments exceeds those that one must achieve on stock and (many) commodity investments.
Second, there is the phenomenon of Gibson's Paradox. Gibson's Paradox, simply put, is the observation that interest rates rise alongside prices. John Maynard Keynes made this observation when looking at the gold standard period, but if investors look at the bond market of the 1970s, when inflation was very high, Gibson's Paradox held despite the fact that the United States went off of the gold standard in 1971.
Despite this bond prices do seem to be rising in the 21st century, which would contradict Gibson's Paradox. But this rise is illusory when corrected for inflation; and if we measure bonds against gold (i.e., if we look at bonds as if we had a gold standard), then it becomes obvious that bonds are falling.
Third, interest rates are negative when they are corrected for inflation as measured by John Williams' CPI. The former, as given by the 10 year Treasury Bond, are roughly 2%, while the latter is around 7%-9%. Real interest rates are at best -5%.
B'--Inflation Protected Securities
Inflation protected securities are "inflation protected" in name only. First, any gains that inflation protected bonds produce as a result of inflation are taxed, and therefore they cannot be inflation protected under any circumstance unless they are held in a tax-sheltered account such as an IRA. Second, inflation protected securities are linked to the CPI, which is artificially deflated by hedonic adjustments and substitution bias, and consequently they do not give investors real inflation protection.
While some foreign currencies may outperform the U.S. dollar it is unlikely that they will fully protect investors from inflation. Many central banks have openly stated that they will fight money supply contraction by expanding their monetary bases and backstopping distressed debt. Furthermore, all foreign central banks can theoretically act in kind even if they are not doing so currently, and any so-called "strong" currency can become weak at any moment. This has happened recently to currencies such as the Swiss Franc (FXF) and the Japanese Yen (FXY), both of which saw huge setbacks relative to the dollar upon the announcements of central bank policy changes. Ultimately the reasons investors would avoid holding U.S. dollars or U.S. dollar denominated bonds apply to all foreign currencies.
Still there may be some currencies worth owning. Currencies in countries where there is a lot of commodity production may see rising demand for their currencies because people must buy their currencies in order to buy commodities from them. The Canadian Dollar (FXC) and the Australian Dollar (FXA) are good examples. Nevertheless investors will likely benefit more from owning the commodities that are produced in these countries than from owning these currencies, as has been the case thus far in the 21st century.
Stocks are often misconstrued as good hedges against inflation. Yet during periods of high inflation investors demand higher returns, which implies that stocks will trade at lower P/E multiples and with higher dividend yields. For example, during the inflationary period of the 1970s the P/E ratio on the S&P 500 declined from about 15X-20X earnings to below 10X earnings. Thus it is no surprise that during the 1970s stocks failed to keep up with the CPI (which at the time was a better gauge of inflation because it was not corrected for hedonic adjustments or substitution the way it is now):
Furthermore, we saw earlier that in order to keep pace with inflation investors must aim for returns that exceed the inflation rate. For example Coca-Cola (KO) has input costs that correlate with inflation, yet they can raise their prices accordingly. Thus it is conceivable that KO will be able to grow its profits at 10% if inflation is 10%, and over time the stock may appreciate 10% per year. But this is insufficient for investors who wish to preserve their purchasing power, as they require nearly 14% annual returns to accomplish this.
That is not to say all stocks should be dismissed. Given our hypothetical 10% inflation scenario stocks that can maintain their profitability in real terms and that trade at 7.1X earnings or less (a 14%+ earnings yield) will provide sufficient returns. Stocks that trade at a higher P/E ratio can be purchased if investors assume that they will grow their real earnings at a sufficient rate to make the investment worthwhile.
For example, there are some companies that may benefit at the expense of others because the latter see their costs rising faster than the former. Railroad companies are a good example of this. Railroad companies have lower energy costs than trucking companies, and so there is a secular trend toward railroads and away from trucks as a means of transporting goods. Two such railroads that have provided returns in excess of inflation include Union Pacific (UNP) and Canadian National Railway (CNI).
Investors can also consider purchasing stocks of companies that have minimal commodity input costs that have other secular tailwinds. Visa (V) and MasterCard (MA) are good examples. Both companies have low commodity input costs and are benefiting from the global trend away from cash payments towards electronic payments. Both companies have seen returns in their share prices well in excess of inflation.
Here is a summary of my strategy for investing in an inflationary environment.
A: Investors must outperform the rate of inflation because their nominal gains are taxed as if they are real gains.
B: Given the way that capital gains are taxed investors will benefit from holding their investments for long periods of time.
C: Commodities are the best inflation hedges, and commodities that have a high value to weight ratio should benefit the most.
D: Commodity-stocks are also good inflation hedges if they are chosen wisely. Investors in commodity stocks need to remember that these companies experience inflation both as a tailwind and as a headwind.
E: Bonds are a lousy inflation hedge, and inflation protected bonds cannot protect investors from inflation because the nominal gains that are meant to hedge investors against inflation are taxed.
F: Foreign currencies are lousy inflation hedges, although some are better than others. Currencies in countries that produce commodities should fare slightly better but they are poor substitutes for commodities themselves.
G: Non-commodity stocks are not good inflation hedges in general, yet there may be companies that benefit from prices rising, and there may be others that have their own secular tailwinds that make them solid investments regardless of inflation.