Conrad Seastrunk, Florence Financial Advisor, Florence Financial Planner, Florence fee only financial planner,
Inflation Hedges and Inflation Beaters
In financial circles, there's been a lot of talk about inflation. The Fed wants to encourage a moderate inflation increase and is holding interest rates low until that happens. Pessimists, though, worry about that approach. The thinking is that pent-up demand from the pandemic lifestyle could drive a sudden rise in spending once COVID-19 is under control. That influx of money into the economy would push prices higher -- potentially driving inflation above the Fed's target of just over 2%.
A short-term period of slightly higher inflation wouldn't be memorable, but an extended run of inflation above 3% can be problematic. It raises your cost of living and chips away at your investment returns. Inflation can also increase the cost of new borrowing. First, lenders may want to charge more to offset the value they lose to inflation by the time their debtors repay. And then, the Fed may deploy its go-to move to combat inflation, which is to raise interest rates.
When thinking about how to inflation-protect a portfolio, I think it's useful to segment those inflation-fighting investments into three key groups: broad inflation hedges, narrower inflation hedges, and what some call "inflation beaters"--investments that don't track inflation directly but that have historically out-returned inflation by a healthy margin over time. We tend to need the hedges more when we're older than when we're younger, while investors of all ages need their investments to beat inflation--at a minimum.
Retirement portfolios should include a blend of inflation hedges and inflation beaters.
Pre-retirees and retirees can protect their plans against inflation in a few different ways. They can make sure they're
factoring in their own situations and spending patterns when deciding how big a deal inflation is for them. Inflation should also play a role in how they think about taking withdrawals from their portfolios
Inflation hedges are investments whose values go up when higher inflation comes on line. These investments can be further subdivided into two groups: those that aim to reflect inflation broadly, as measured by the Consumer Price Index, and those that reflect higher prices in a smaller basket, such as commodities or real estate.
In the former group, TIPS and I Bonds both help the value of their investors' accounts keep pace with the Consumer Price Index for All Urban Consumers (CPI-U). If inflation, as measured by the CPI-U, goes up, the TIPS owner receives an increase in his/her principal value. If inflation goes down, the principal value goes down, too. The interest paid on the bond is also indirectly affected by these changes to the principal value. Upon maturity, TIPS owners receive their original principal or the inflation-adjusted principal, whichever is greater.
I Bonds work similarly. In addition to a fixed rate of return set when the bonds are purchased, I-Bond holders also receive semiannual adjustments to their interest levels based on changes to the CPI-U. A crucial difference is that TIPS holders receive semiannual interest payments, whereas I-Bond holders receive their accrued interest when their bond matures or they redeem it. I Bonds offer tax deferral because of that feature; the income isn't taxed until the bond is redeemed.
From a practical standpoint, many investors opt for TIPS mutual funds for simplicity and ease of use. Moreover, I Bonds have severe purchase constraints that limit their effectiveness for larger investors who are aiming to build a significant bulwark against inflation. Investors are limited to $10,000 in electronic purchases of I-Bonds per Social Security number per year, and an additional $5,000 in paper I-Bond purchases are available for each Social Security number per year.
Because they offer inflation protection, principal protection, and government backing, TIPS seem like the ideal asset for retirement. But TIPS' return potential is low: TIPS' yields are currently negative, with the assumption being that TIPS' future inflation payments will make holding them worthwhile.
Another category of inflation hedges reflect price changes in narrower slices of the economy, either directly or indirectly.
Commodities-tracking investments are the best example in this category: They aim to reflect price changes in items like basic materials, energy products, and agricultural products, which in turn affect the prices we pay for a lot of our basic needs.
Other inflation hedges in this group are narrower still. For example, real estate investment trusts have fared reasonably well as inflation hedges. That's because the owners of the apartment and office buildings, shopping malls,and hotels in REIT portfolios are often pushing through rent increases at times when inflation is running up, which in turn enhances REIT payouts and security prices.
Contrary to conventional wisdom, gold hasn't been a particularly effective inflation hedge, even though it's often cited as such.
There are a couple of big issues with these types of inflation hedges, which is one reason it's wise not to go overboard with them. One is that unlike TIPS, they don't reflect the broad basket of goods and services that consumers spend money on. Even the broadest-based commodities-tracking funds obviously won't reflect changes in service categories like health care delivery, hair salons, cable TV subscriptions, or gym memberships. REITs reflect inflationary changes in a smaller part of the economy still. Thus, there's a risk that they won't defend against the type of inflation you're experiencing.
Perhaps more important, these investments are quite volatile: If you happen to buy in at the wrong time, as many investors did by racing into commodities following their run up in the mid-2000s, that reduces the inflation-protective benefit that you might derive from them. Of course, the fundamental case for commodities looks better today than it did back then, but commodities have already experienced a significant run up over the past year. I think the bigger issue, though, is that the risk/reward profile of commodities is a mismatch for the problem they're trying to solve. In most periods, inflation is a slow but steady drain on your portfolio's purchasing power, so it seems odd to hedge against it with an investment where you could gain or lose large sums over a short period.
What we call "inflation beaters" don't match inflation on a one-for-one basis but rather have a record of delivering returns well above inflation over time. Retirees who are actively drawing from their portfolios need both types of inflation protection--inflation hedges to help preserve their purchasing power and inflation beaters to help their long-term investments grow at a rate in excess of inflation.
Stocks are obviously the top asset class in this category: While near-term return expectations (over the next 10 years) for U.S. stocks are muted in several expert forecasts, over longer periods of time during modern market history stocks have out gained the inflation rate by about 5 to 7 percentage points.
Can certain types of equities do a better job of protecting against inflation than others? Potentially so. Though modern market history provides few truly inflationary periods to examine, companies with a history of increasing their dividends may provide a measure of inflation protection. In contrast with companies whose dividends aren't increasing, dividend-growth companies' payout increases may help them keep up with inflation. The good news for retirees is that such companies are historically higher-quality and less volatile than the broad market.
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