- Inflation is a top concern for market investors and signs are clear that inflation is trending higher with tight labor markets and an economy running at capacity.
- While looking for inflation protection, investors should look no further than stocks, especially those that provide flexible margin power to raise prices and pass of higher input costs to consumers.
- Other traditional inflation hedges - gold, oil, TIPS and real estate - all have their pros and cons, but don't compare to the qualities of equities.
"Inflation is a way to take people's wealth from them without having to openly raise taxes. Inflation is the most universal tax of all." - Thomas Sowell, economist
Inflation is at the top of mind for most investors these days. While there are many contributing factors that led to the recent market sell-off, most analysts point to the unexpectedly high US wage data released on Friday, Feb. 2, as a primary culprit. To be sure, the reasons to be concerned about inflation run aplenty: a full labor market operating at capacity, rising wage pressures, accelerating growth driven by the fourth industrial revolution, tax cuts resulting from large-scale fiscal stimulus measures, buoyant consumer confidence, and so on. A majority of market participants cite inflation as their primary market concern from a survey of market respondents. But how can investors protect themselves from the impending "inflation dragon"? Equities provide investors a unique and historically robust way to hedge their inflation exposure.
Does Wage Inflation Lead to Price Inflation?
Wages and labor input costs is a particular dataset that has caused a ruckus among market participants and drawn a lot of fanfare. Without a doubt, most have their eye on this dataset every first Friday of the month, almost supplanting the Non-Farm Payrolls as the preeminent economic figure. However, do wages actually lead price inflation or vice versa? There's a lot of debate on this topic, but empirical research from both the San Francisco Fed and the Cleveland Fed both suggest that wages do not contain much useful information for forecasting price inflation that is not available from other inflation indicators.
In fact, the Cleveland Fed study found that there's little empirical evidence to support the view that higher wages cause higher prices. But the relationship might even be the reverse -- higher prices lead to wage growth. Regardless of these studies, the market is undoubtedly paying attention to all-important wage indicators such as the National Federation of Independent Business' Compensation Plans Survey data. The Atlanta Fed's Inflation Dashboard reveals that labor costs are on the 100th percentile of a common three-month trend of the underlying wage series, citing unemployment claims (238k), high average hourly earnings (0.6%), and the low Unemployment rate of 4.1% as contributing factors for this extreme reading.
At its core, the Federal Reserve targets a neutral rate of inflation around 2% by changing the monetary base. A rise in money supply increases the dollars in circulation that flow into the economy, which should, in turn, impact consumer price inflation. However, the fact is that changes in the monetary base have a more direct relationship with asset price inflation rather than consumer price inflation. This not-so-subtle difference is the reason history sees asset prices -- real estate, stocks, private equity investments -- increasing at a much faster clip than the pace of consumer inflation (the prices you pay for everyday items like food, clothing, shelter and gasoline).
In particular, increases in the money supply allows for money to flow into non-physical, tradable and liquid financial assets such as stocks and bonds at a much faster clip than it takes to "trickle down" into the actual economy via higher wages and consumer prices. It's no wonder that Wall Street applauds central bankers after dovish comments or unexpected rate cuts. In fact, many Federal Reserve members have recently been discussing their opinions on the symmetry of the 2% inflation target, spelling out a scenario where they could potentially "let the economy run hot" at 2.5% inflation without getting worried, counterbalancing the recent period of 1.5% inflation. As the wealthy typically own the majority of financial assets, this also contributes to the wealth inequality divide between the "haves and have nots," but that's a different topic for a different day.
Why Are Stocks the Best Way to Hedge Inflation?
"There are two main drivers of asset class returns - inflation and growth" - Ray Dalio
Inflation flows into financial assets via asset inflation.
Equity indices are priced in nominal dollars, not inflation-adjusted real dollars, which means there is an inflation protection component embedded within stocks. Because companies have an ability to increase prices on consumers to maintain profit margins, equity investors benefit from this margin optionality. In addition, an expanding monetary base automatically funnels resources into stock markets via the transmission channel. Just observe what happens when Jerome Powell or another central banker sounds hawkish versus dovish during a speech. In addition, partly due to the lack of suitable investment alternatives, stocks tend to overshoot inflation at the end of a stock market cycle. While investors typically purchase stocks for their fundamental story or attractive opportunities, they are also receiving a call option on runaway inflation.
For a case in point, take the example of what happened to the Turkish Stock Market (ISE 100) during their hyperinflationary periods of the past. The Turkish stock market stood at a value of 1 in 1986 and by 2010, it stood at 55,000 -- an enormous amount of appreciation. But did Turkish investors make a fortune? It depends on how one looks at it. When subtracting inflation, in real terms the ISE 100 barely appreciated during this time period. However, if you were living in Turkey and kept your money in Turkish government bonds, cash or under the mattress, you would have suffered financial calamity during their hyperinflationary period. No other inflation hedges would have delivered equivalent returns as the stock market. A similar event unfolded in Zimbabwe as Mugabe devalued the currency, sending investors to the stock market to seek inflation protection.
Companies can pass rising costs to consumers.
Despite rising input costs, companies with bargaining power can typically pass off price increases onto their customers. This is especially the case for basic items of necessity -- household goods, etc. -- that consumers cannot live without. In the event of a significant rise in consumer prices, consumers may cut back their amount of spending, especially if consumer price inflation outpaces wage inflation. Superior companies with reputable products and services may even be able to increase prices at a faster clip than overall inflation, justifying their actions with a quality good or service.
As shareholders of a company, equity investors stand to benefit from this margin expansion. Or, at the very least, they will be able to keep pace with the rate of inflation. Other than real estate investments that can raise rental prices (usually just once a year) and TIPS, traditional inflation hedges don't offer a dynamic price increase commensurate with the rate of inflation, contributing to asset inflation.
Bond outflows lead to equity inflows.
While bonds, which represent roughly half of the financial asset universe, almost always decline in value during an inflationary period, stocks benefit from these would-be bond flows pouring into equities. The acronym TINA -- "there is no alternative" -- has gained traction over the last five years as the universe of investable assets has decreased, giving rise to alternative assets like Bitcoin, and investors have resorted to either moving to the sidelines or investing in equities. As the extraordinary period of ZIRP and Quantitative Easing comes to an end and the bond market looks to be entering a bear market this decision -- stocks or sidelines -- has been forced upon real money investors. It's a well-known fact that cash is the last place one should look to provide protection from inflation.
Ease of transaction relative to other inflation hedges.
Unlike a very popular inflation hedge, real estate, stocks are easy to transact and can be purchased and sold at the click of a button. This allows investors to tailor their inflation protection exposure over varying time frames, allowing them to manage their inflation exposure. Apart from ETFs that grant direct investment access, physical gold and oil -- two other popular inflation assets -- are also difficult to purchase and store. Finally, Treasury Inflation Protection Securities come with their fair share of transaction fees and brokerage costs, eating away at the incremental inflation protection gains.
Other Assets Typically Used as Inflation Hedges Don't Compare to Stocks
"There are only three ways to meet the unpaid bills of a nation. The first is taxation. The second is repudiation. The third is inflation." -Herbert Hoover
While there are many other forms of achieving inflation protection, they each come with their own unique downsides that don't provide the same quality of inflation protection typically found in equities:
1. Gold: Probably the first thing that pops into investor's minds when thinking about inflation hedges, gold has historically exhibited positive correlation to inflationary periods. This may be because investors hark back to the collapse of Bretton Woods in the early 1970s when Nixon unilaterally pulled the USD off the gold standard. However, gold is a function of its denominator: the U.S. dollar. If the USD is rising during an inflationary time, perhaps due to expectations of Fed rate hikes, gold will not significantly appreciate. Gold is a function of real rates, roughly described as nominal rates minus inflation expectations, and an aggressive central bank could damper gold's appreciation via nominal rate increases.
2. Oil: Traditionally, oil has moved with, and perhaps contributed to, the rise of inflation. As a significant input cost to many family's household budgets and corporate balance sheets, this resource can impart a catalyzing affect across a number of consumer items. As the U.S. saw with the Arab embargo petroleum crisis in the 1970s during which OPEC decided to stop exporting oil to the U.S., oil prices more than quadrupled within a short amount of time. However, unlike this politically motivated period of time, which saw crude oil explode from $2.90 to $11.65 a barrel, the U.S. now has significant means to counteract any OPEC embargo with the advent of shale drilling. Shale drilling enables horizontal extraction of shale oil and has allowed the U.S. to become energy independent, even exporting to other countries. Thus, in the event of a surge in inflation, it's not clear that oil prices will increase hand in hand.
Source: Owen Franken/Corbis via Getty Images.
3. Real Estate: Like financial assets, real estate is often a popular choice to protect against inflation as it's a hard asset. In fact, during many hyperinflationary periods in Latin America, real estate owners that were fortunate enough to have purchased with large mortgages saw the value of their debt diminish with inflation while their property values skyrocketed, winning on both ends of the spectrum. Not only do real estate values rise in an inflationary period, but they're solid passive income vehicles by generating rental income streams which can rise with inflation (both wage and consumer). However, real estate is not a very liquid investment, often requiring weeks and months of inspections, licenses, mortgage approvals, brokerage fees and other forms of friction that make purchasing an arduous process. In addition, because of the large upfront capital commitment, many investors don't necessarily have the resources or capital to make this an easy, effective inflation hedge. REITs provide an alternate option, but they're also usually layered with fees and it's more akin to a financial asset.
4. Inflation-Indexed Bonds: Treasury Inflation Protected Securities, also called TIPS, are a popular inflation hedge investment as their value derives directly from the Consumer Price Index. As the index rises, the base value of TIPS increases as well as the interest payment tied to that the base value increase. However, this type of inflation hedge is subject to calculations and construction methodology of the Consumer Price Index, which is not the same as Asset Price Inflation. In this case, your real purchasing power of your investment merely increases at the rate of inflation, akin to just bobbing on top of the water.
Which Equity Sectors Provide Inflation Protection?
As a rule of thumb, when looking for sectors and stocks that will provide inflation protection, you'll want to focus on those with maximum pricing power with the ability to raise prices if input costs accelerate. These are products and services that are necessities for basic economic functions but also very important products and services, without which much of the economy cannot live without. Consumer staples are an obvious choice as consumers will be forced to pay up for any price offered, but there are a few unique alternatives in the hardware, semiconductors and software space.
As the global economy is in the midst of the fourth industrial revolution focused on a digital economy, these sectors play a pivotal role in keeping the digital engine running. A few ETFs that provide adequate exposure to these sectors are the XTH (hardware), SOXX (semiconductors) and IGV (software) exchange-traded funds, all of which have been performing admirably over the past six months as inflation has picked up apace. Look for those to continue their robust performance, especially if inflation gains steam in the future.
Source: Taken from "When Money Dies," by Adam Fergusson.
"By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens." - John Maynard Keynes
As legendary investor Jim Leitner says in The Invisible Hands, "Real money managers should not be all that nervous about long-term inflation since the majority of their portfolios are in equities. What they should be nervous about, however, is managing the short-term volatility of the portfolio in the interim." Concerned about a long-term hyperinflationary period? Long-dated, out-of-the-money equity index call options provide cheap ways to gain access to inflation protection. While traditional inflation hedges don't always work, equities can provide investors access to inflation protection with unique advantages.
As final food for thought, the current U.S. administration has embarked on aggressive fiscal expansionary policy exactly at a time that the country is experiencing its strongest growth in years. This has increased the budget deficit and burdened future generations with the growth we're seeing today. Growing budget deficits are a harbinger for currency depreciation -- a fact playing out with the U.S. dollar -- which can manifest in higher inflation. Meanwhile, labor shortages are cropping up across the country, inevitably due to the difficulty of finding quality labor, which may be a reflection of the current immigration policy stance. While the Fed is continuing to run down its balance sheet and hike interest rates, the monetary base is still significant in size. Finally, as a real estate investor knows that the best way to reduce debt and deficits is via higher inflation, the president's current actions speak volumes on the probable path of "letting inflation run hot." However, equities can provide investors quality protection in the event of that higher inflationary outcome.
So where are you going to invest your assets?
This article was written by
Analyst’s Disclosure: I am/we are long QQQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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