Some say inflation is easy to understand but the impacts from it are anything but easy – especially the impact on your investment portfolio. So let’s dig in a little – What is inflation and what are the best investments for rising inflation?
How are we at Cashflows & Portfolios fighting inflation with our investment portfolios?
Read on to find out and of course, comment away including what you’re doing about it.
What is inflation?
At the most basic level, inflation is an increase in the price of goods and services over time.
For example, if the inflation rate is 2%, then a loaf of bread today that costs $1 will cost $1.02 the next year. Of course, bread is more expensive than $1 or even $1.02.
Simply put, inflation erodes purchasing power.
Are there benefits to low inflation?
Yes, we believe so.
When inflation is low, rather, low and stable then this is generally good for the economy. A stable and predictable rate is easier to plan for while demonstrating the economy is growing. When things are predictable, companies are more likely to grow their businesses when they know what their costs will be many months or even a few years ahead. This is also good for shareholders – you can potentially count on these businesses to grow at at stable pace!
Growing, predictable businesses can also spin-off benefits like more jobs, higher overall income levels, allowing people to spend their money on goods and services.
Are there benefits to high inflation?
In our opinion, no.
Given this affects everyone in the economy, and it often imposes some higher costs for all, then this becomes problematic. Higher rates of inflation deliver unpredictability, and that’s challenging for businesses and individuals to adapt alike.
What does the rate of inflation mean?
To measure it, we look at the consumer price index (CPI) from the Bank of Canada.
- In one year, the basket of goods and services the CPI uses costs $100.
- The next year, the same basket costs $102. So, like our bread example, that means the average annual rate of inflation is 2%.
The Bank of Canada has historically targeted to keep the inflation rate in any given year between 1-3%, a comfortable range. Of course, inflation is not an easy thing to control….history tells us so!
How inflation works – why should it matter to you?
Essentially, prices tend to go up when the demand for goods and services is more than the economy supplies. Alternatively, prices tend to come down when the economy supplies more goods and services than people want or need.
Let’s look at a few key problems when it comes to inflation.
1. Problems for borrowers and lenders
If inflation turns out to be higher than expected, then the debtor benefits because the repayment (adjusted for inflation) turns out to be lower. If inflation turns out to be lower than expected, then the creditor benefits because the inflation-adjusted repayment will be higher than what was anticipated by both parties. If you have a fixed rate mortgage for example, and have a locked-in your mortgage rate for the coming years, higher inflation won’t really concern you related to your mortgage.
2. Problems for savers and investors
When inflation becomes less predictable, uncertainty ensues. Higher uncertainty about future inflation will also extend to greater uncertainty about interest rates, wages, taxes, and profits. In response, businesses may delay or postpone hiring decisions. Businesses might not spend as much money on equipment. Households may cut back on consumption. Savers may tend to save more. All these responses can lead to a lower-growth economy. So, while some inflation is good, just like eating lots of chocolate – a lot of inflation is bad.
When inflation runs too high, happens too fast, or occurs for too long – it is really not good for anyone. Unless you have a lot of money to saved or invested, higher inflation will eat into your spending power, can produce low growth, and consequently lead to higher employment across the economy.
How fast can prices double?
While Canadians usually don’t pay much attention to inflation – we bet they are paying attention now at the time of this post.
On average, throughout the 1970s, prices increased by about 8% per year. At that rate, it would take only 9 years for prices to double. When inflation is around 2% per year, it takes about 35 years for prices to double.
(Prices doubling every 9 years is exponentially bad. Prices doubling every 35 years is far more adaptable.)
Right now, the cost of goods and services is on the way up!
According this latest MoneySense article:
“Throughout the first half of 2021, inflation has variously been depicted as an ominous looming threat, or merely a “temporary” spike, triggered by the COVID recovery. It’s certainly been inching up this summer: food prices are at their highest level in almost three decades, and the prices of housing, energy and even used cars are soaring. U.S. inflation is up 5.4% versus a year ago and is at a 13-year high.”
So, with inflation, there are always winners and losers:
What are the Best Investments for Rising Inflation?
In terms of your investment portfolio, here are a few quick considerations for the best investments for rising inflation:
1. Stick to a bias of stocks.
We believe a stock portfolio unto itself can be a good inflation hedge. Companies can push their increased manufacturing and service costs back onto customers, to a point, to keep their revenues flowing in and costs may climb. Of course, some stocks such as those in the following sectors may be more inflation-friendly than others:
- Consider owning Real Estate Investment Trusts (REITs).
- Consider owning commodities.
- Consider owning materials.
2. Consider the “Permanent Portfolio”.
The permanent portfolio is an investment portfolio designed to perform well in all economic conditions. It was devised by free-market investment analyst, Harry Browne, in the 1980s. This portfolio is composed of equal parts stocks, bonds, gold, and cash. In terms of low-cost U.S. ETFs, it looks a little bit like this:
“So if many portfolio managers and financial planners don’t consider serious inflation or the possibility for a change in economic conditions (economic regimes) it’s not surprising that the everyday retail investor would not ‘get it’. And by the way, I am told that advisors and planners are not trained ‘on this’. They are not trained to protect your wealth in all economic conditions. The word “stagflation” does not show up in their training materials.”
3. Own the TSX!
Yup, not all sectors are negatively impacted by inflation. So, to hedge your portfolio against inflation, consider investing in sectors that will see pent-up demand, like oil, electricity, and real estate. In fact, one could make a case that financials might do well in a slightly inflationary environment. When it comes to those sectors, look no further than the TSX.
Sure, as far as recessions go, banks and large financials are probably not ideal investments for superior short-term returns. Banks are very cyclical in that sense – when bad times hit – you’ll see housing demands drop, you’ll see other loan demands drop and we saw this during the first part of the COVID pandemic. But, banks are gonna bank. Banks are engineered to make money, lots of it, during mildly inflationary environments.
So, with that, given the TSX index is heavily weighted in both energy and financials, it might not be a bad place to keep some of your money during some inflationary times, let alone as part of a long-term investment plan, in the TSX.
See the following sector allocation in the Vanguard Canada – FTSE Canada All Cap Index ETF (VCN):
Source: Vanguard Canada.
How are we at Cashflows & Portfolios fighting inflation with our investment portfolios?
Well, in fact, we’re doing next to nothing.
For one, we already own a nice basket of stocks via low-cost ETFs to ride the market returns. We outlined some of our favourite low-cost ETFs in this post here:
Second, we also happen to own a few dividend-paying stocks in each of our portfolios. We own some REITs, commodities and some material stocks (e.g., Nutrien (NTR)) to help fight inflation.
Lastly, we’ve seen this movie a bit before. We’ve learned from The Four Keys to Investing Success.
Inflation is bound to rise and fall and rise overtime again. As such, we’ve designed each of our portfolios based on lessons learned from history to hold a bit of cash (maybe not as much as Harry Browne!) and keep other sectors in our portfolio (such as some technology stocks) through indexing the U.S. market. This way, using the tech sector-heavy U.S. market as an example, that’s a small hedge to ride out any higher but short-term inflationary period. I mean, who doesn’t like a new iPhone now and then? Will people really stop using paying their electricity bill to use the internet? We doubt it.
Final Thoughts – What is inflation and What are the Best Investments for Rising Inflation?
At the core, inflation is an increase in the price of goods and services a consumer pays. Some might say you get less for the same price. Either way, some inflation, is just fine. If inflation rises at a faster rate than your investment returns, over time, well you might have a problem.
While we don’t personally see inflation running amuck again like the early 1980s, never say never. High rates of inflation can be killer to your portfolio value so what are the best investments for rising inflation?Best to learn to live with stocks, remain diversified, and for the most part just stay invested as part of a long-term plan.
If you are going to keep some cash make sure you consider the Best High-Interest Savings Accounts in Canada.
Finally for today, for any deep-dive into owning more equities over time, including in retirement (!), check out Michael Kitces work in this post: why a rising equity glidepath during retirement is better.
Thanks to fan of the site Dale Roberts from Cut the Crap Investing for this fine reference.
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