On my post about 2018 Investment Outlook, I wrote about how I thought (and still think) that with all that free and easy money from central banks out there, it’s difficult to believe in a crash that doesn’t rebound shortly after.
For now I’m confirming my theory as the mini crash that we saw in the stock markets, (first weeks of February) it’s apparently over. Some have said in the past that most 10% corrections end without a recession or bear market.
Corrections in bull markets are typically short-lived.
One thing I’m keeping on my outlook, is that there are at least two ways that my optimism will end immediately.
- Major geopolitical event
- Inflation shows up (meaning levels above 2%)
What is Inflation?
The US economist Milton Friedman once said “inflation is taxation without legislation”. But what exactly is this?
Definition: Inflation is the rate at which the general level of prices for goods and services is rising. Therefore meaning that the purchasing power of currency is falling.
If the inflation rate is 2%, then a coat that costs $100 in a given year will cost $102 the next year.
Who can control this?
The primary objective of central banks (such as ECB, BoJ or the FED) is to keep prices stable. That means prices should not go up (inflation) significantly. Same goes for falling prices (deflation). This is because long periods of excessive inflation or deflation have negative effects on the economy.
For people that go into retirement (specially early retirees) it’s very important to maintain the purchasing power, and to have real returns on their investments. If you have long periods of high inflation, without real returns on your savings/investments, you can lose a substantially part of your purchasing power. Therefore not being able to buy the things you need.
Ways to Hedge Against Inflation
Here are some strategies (only for information purposes, not financial advice) that may contribute to the protection of your portfolio against inflation:
- Invest in stocks. Companies are structures that know how to adapt to inflation, by increasing the price of goods and services that they sell. Thus on the long run, it will lead to elevated revenues, earnings, and inevitably, stock prices. A simple, and low-cost ETF should be enough to implement this idea. Plus the companies that don’t adjust (and go bankrupt) will eventually exit the index, and will be substitute by others.
- Go international. If you invest in other countries/regions, it can help to hedge your portfolio against domestic economic cycles. Because inflation in other places may not rise and fall in tandem with the U.S. for example. Again a simple and cheap ETF that invests in stocks worldwide should be enough for this option.
- TIPS. Treasury inflation protected securities (TIPS) are designed to increase in value in order to keep pace with inflation. Normally these are bonds which have a link to the value of inflation. The problem here is if you have deflation the value of TIPS will be negatively effected. Theoretically.
- REITs. Real estate investment trusts (REITs) carry holdings in residential, commercial and industrial real estate. If inflation goes up, with everything else equal, you will have higher values for rents and/or higher values of properties that REIT is developing to sell in the future. So in theory it can be a good hedge against inflation. Bare in mind that there are other factors that could affect the return of REITs.
Ways That I Don’t Recommend
- Gold. This option I wouldn’t use. Evidence has showed that gold is a poor solution to defend a portfolio from short-term inflation.
- Bonds. Individual bonds can be a poor choice too. Imagine holding a bond for 10 years with a 1% return per year, and inflation in those 10 years with a rate of 3%. The real return (Yield) is -2%. On the other hand an ETF of bonds can be a good solution on the long term, because newer bonds issued will have higher returns.
Inflation can have a really negative effect on your savings, so every investor should know what options there are to protect or at least decrease the negative effect on the return of your investments.
Broadly speaking, a return producing asset that has an ability to adjust, such as stocks or REITs, should have a positive real return on the long run. There are other factors to take into account, but everything else equal, an investor should be fine.
There is a difference between an individual stock (where the risk is superior) and an ETF of stocks. The first one you are incurring in an individual risk of that company doesn’t adjust well to inflation. An ETF with a broad group of stocks of all over the world, that individual risk is strongly mitigated.
Another argument that you should look, is that today in developed countries we have central banks with instruments and capabilities to quickly fight high levels of inflation. In that way, if central banks keep their independence from political parties and governments I believe that we will never see high levels of inflation for a long period.