Inflation Is Coming: How Not to Prepare
There are several signs that inflation is creeping into the U. S. economy. This should come as no surprise to investors who follow the Federal Reserve, which has been significantly increasing the money supply through its quantitative easing program. Even with the latest “taper” program in place, the fact remains that the Federal Reserve is increasing the monetary base by about 1 percent per month.
Now a rise in the money supply doesn’t immediately lead to rising prices. There are several factors that go into pricing. The fact that banks haven’t been lending to the extent that they have in the past indicates that they have a very high demand for money. Since prices are determined by both the supply and the demand of money we haven’t yet seen inflation.
But recently, we have seen hints of inflation coming into the market. While the CPI is a questionable indicator, last April’s increase of 0.3 percent annualizes to an inflation rate of 3.66 percent, or about twice the prevailing rate in the recent past. Furthermore, we have begun to see a rise in commodity prices. Take a look at the performance of a couple of the broader commodity ETFs year to date. The broadest that I follow — the Rogers Commodity ETF (RJI) — is up 5.3 percent year-to-date. Specific widely used commodities such as oil and corn are up even more than this despite the fact that the economy has been somewhat weak.
As a result, I think investors need to begin to prepare themselves for inflation. But there is a lot of misinformation out there regarding the best way to prepare for inflation, and so in what follows, I want to point out some assets to avoid in an inflationary environment despite the fact that others would argue to the contrary.
1. Inflation Protected Securities (i.e. TIPs)
The Treasury sells inflation protected Treasury Bonds, and these are marketed as a good inflation hedge. Don’t be fooled. There are problems with using TIPs as a hedge against inflation. The first is that it is tied to the CPI, so that the payments increase if the CPI increases. But the CPI is a questionable index that employs several techniques that suppress the stated inflation rate. For instance, the CPI uses a technique called substitution bias, which essentially says that if the price of something goes up too much then consumers will switch to a similar alternative, which essentially means that the statisticians who calculate the CPI are removing items from the basket of goods if they rise too much in price.
The second is that TIPs income is taxed. So even if the CPI were perfectly accurate, you wouldn’t be fully protected against inflation.
Stocks are pieces of ownership in real businesses, and people argue that stocks therefore protect you against inflation. After all, the real value created by businesses is still the same whether or not the currency loses value or not. While this is true to a certain extent, keep in mind that these businesses have input costs, and if these input costs rise then businesses have to decide whether to pass the increases on to consumers or not. For instance, Chipotle (NYSE:CMG) saw its commodity costs rise in the first-quarter, and it saw its margins decline. While the company responded by raising its prices, it still lost some earnings due to inflation. Also the fact that the company raised its prices now means that fewer consumers will eat at Chipotle.
In short, there is a very real and complex interaction between businesses and the prices of goods in the marketplace, and as an investor in an inflationary environment you need to be prepared for this. Some businesses may benefit because their production costs rise more slowly than their selling prices. But others will suffer like Chipotle. It isn’t easy to figure out which businesses will benefit from inflation, especially if inflation gets to be high and prices become more volatile.
3. Real Estate
Contrary to popular opinion, real estate is not a good asset to own in an inflationary environment. People think that, like stocks, real estate is a tangible asset — the real value of which is distinguishable from currency price fluctuations. But this simply isn’t true. There are three reasons for this. First, real estate is a depreciating asset. It wears down over time unless you spend money on repairs. In an inflationary environment, these costs rise, and this in turn makes the real estate less appealing.
Second, the value of real estate is heavily dependent upon interest rates. If interest rates fall, then it costs less money to service debt, and therefore a given income can be used to service a larger amount of debt. The opposite is also true if rates rise. If inflation rises, then interest rates will rise because the amount of money that lenders are willing to accept on a loan is dependent on what the money is going to be worth in the future. If inflation is high, then lenders will demand a higher rate of return. So if we see inflation pick up then mortgage rates will likely rise, and this means that a given salary can afford to service less debt. So while the dollar’s lost value will put upward pressure on real estate, rising interest rates will put downward pressure on real estate prices as well.
Third, another valuation factor for real estate is rent prices. If interest rates rise, is is likely in an inflationary environment, the amount of rent that an investor wants on a piece of property of a given value will rise. If rents do not rise, then the value of this property will fall to reflect the investor’s demanded return on invested capital.
Disclosure: Ben Kramer-Miller has no position in the stocks mentioned in this article.