Key Takeaways
- Inflation increased by 0.4% in September, meaning high prices are likely to be around for some time yet.
- There are a surprisingly high number of investments that can be used to hedge against the impacts of inflation
- Some, like gold, have been around for thousands of years and some, like TIPS, are more modern and sophisticated
With the latest figures out yesterday, it’s clear that inflation isn’t going anywhere soon. The announcement for September sawa prices rise by 0.4%, which brings the annual rate of inflation down ever-so-slightly to 8.2%.
In the context of a target inflation range of between 2-3%, the current rate is still eye wateringly high. With the Fed determined to bring it down through the hiking of interest rates, it is likely to continue to slowly come back down to earth.
The problem is that this could take a while, and investors still need to generate returns in the meantime. Luckily, there are a number of different investment assets that hold up well against inflation.
Some of these are pretty recent innovations, and some of them go back to when humans used horses to get around and had no flushing toilets.
We’re going to give you an overview of these investments, the pros and cons of each and how you can structure your portfolio with the aim of weathering the impacts of inflation.
Download Q.ai today for access to AI-powered investment strategies. When you deposit $100, we’ll add an additional $100 to your account.
What does inflation do to investments?
A little bit of inflation is actually often considered a good thing for the economy as a whole. Prices that are rising modestly encourages people to go out and earn more and invest their money, and encourages companies to innovate and improve their businesses.
This is because if your wealth or income stands still, it goes backwards in real terms slowly over time as prices rise around you.
When inflation gets too high though, it puts pressure on household budgets and can reduce spending on certain things. The last year or two has been a perfect example of this. With the price of necessities such as gas, energy and food rising so much, many households have had to cut back on discretionary spending like electronic equipment, entertainment and vacations.
With less spending in the economy, companies generate lower revenues which in turn means they hire fewer people or even lay them off. This creates a negative spiral that puts the brakes on economic growth and is one of the reasons why the stock market has crashed this year.
Which investments perform well with high inflation?
There are a number of investments that can buck this trend when inflation is high. Now this isn’t to say that all of these will always outperform inflation. Different market cycles can cause volatility for different reasons, so as always the key is to diversify across the different assets available, rather than go all in on one or two.
They also won’t necessarily grow at a rapid pace when inflation is high. In many cases, these assets are designed to simply hold their value rather than fall dramatically. For example if the S&P 500 has dropped -25%, a return from another asset of -1% or +0.25% would be considered a very good result, even if it’s still below your long term target return.
Treasury Inflation Protected Securities (TIPS)
US Treasury securities are essentially loans to the US Government. When you see on the news that they’re borrowing $100m billion for an infrastructure program or military spending, Joe Biden doesn’t head down to the local Wells Fargo branch and fill out some loan paperwork.
To raise the funds, they issue Treasury Securities. Investors such as mutual funds, pension funds and individuals can then purchase these, which provide them a set rate of return over a set period of time, at the end of which they receive their money back.
So right now a 20 year US Treasury is paying a yield of 3.375%. This means that investors who buy $10,000 worth will receive a 3.375% return every year, and then after 20 years they’ll get their $10,000 back.
Now investors aren’t locked in for 20 years, they can sell the bond to another investor, but the bond itself will continue for the full time period.
The problem is that regular Treasuries don’t take into account inflation. So with inflation at 8.2% and a 20 year bond paying 3.375%, the real rate of return after inflation is actually -4.825%. Not a great deal for investors.
TIPS on the other hand, pay a set margin above the rate of inflation. The margin changes but is never less than 0.125%. This rate might look a lot lower than the standard bonds, but it can really pay off when inflation is high.
So as a hypothetical example, with inflation at 8.2% and a TIPS with a margin of 0.125%, the bond would be paying interest of 8.325%. That’s better than almost any other investment out there, especially when you consider it’s 100% backed by the security of the US Government.
It’s important to keep in mind that they can go the other way when inflation is low. If the inflation rate dropped to 1%, that same bond would now only be paying interest of 1.125%.
TIPS make up a large component of our Inflation Protection Kit, which is an Investment Kit we designed to help protect investors against record high rising prices.
In addition to TIPS, this Kit also includes a number of different other assets which have traditionally been successful hedges against inflation. Lets cover some of those.
Gold
One of, if not the oldest investment asset in the world, gold still retains its position as an inflation hedge in today’s modern economy. The history of gold as a store of value goes back to ancient civilizations like the Incas and the Egyptians. Even back then, humans realized that the scarcity and beauty of it made it a perfect commodity to be used for trade and wealth.
The world might have moved on since then, but gold still forms a major part of the global economy. Countries still lean heavily on their physical gold reserves as security for their own global financial dealings.
The US Government still holds the world’s largest gold reserve, with over 8,000 tonnes worth of physical gold stored in places such as Fort Knox.
For investors, there are a number of different ways to purchase gold as part of a wealth preservation plan. You can buy physical coins and bullion. This creates a number of problems, such as how to store it and insure it.
Companies will store it for you, but that can be expensive. You can store it yourself, but you’ll need appropriate security and many home insurance policies don’t cover gold. It’s not a straightforward process.
There are also financial products that can help. There are funds and ETFs which invest in gold, either by holding physical gold on your behalf or by investing in financial instruments such as gold futures.
Other precious metals
While gold is the most common inflation hedging precious metal, there are plenty of others that are considered investment grade as well. The most popular of these are silver, platinum and palladium.
All of these metals have a long history of use in jewelry, industrial applications and as stores of value. You can think of these as small cap metals compared to gold’s large cap. The price is often more volatile, but they can go through stages where they rise in price significantly.
The issues for investors are the same as with gold. Holding physical amounts come with insurance and security challenges or require the trust and cost of a third party security deposit. Again like gold, there are funds and ETFs which can provide exposure without the need to install a fireproof safe at your house.
At Q.ai we’ve created an Investment Kit which does all of the work for you. The Precious Metals Kit invests across gold, silver, platinum and palladium ETFs and uses AI to predict which of these metals is likely to perform the best over the coming week.
Once these predictions are made, our AI automatically rebalances the portfolio in line with the allocation which is expected to provide the best estimated risk adjusted return.
Commodities
Last on our list and another inclusion in our Inflation Kit are commodities. These are resources that are used all around the world with a demand profile that doesn’t change much based on market conditions.
Agricultural commodities such as wheat, wool and soybeans are some examples. Because we rely on these types of goods to meet our basic needs, the level of demand for them tends to stay pretty stable.
While we can all cut back on vacations or sneakers, we’re less likely to reduce our consumption of things like bread and vegetables.
This means that prices for commodities fluctuate a lot based on the underlying rate of inflation, and there are a wide array of financial products such as futures and options based on the prices of commodities.
Another major commodity is oil, which again is used in ways in our economy which are not impacted by inflation. While we’ll grumble about the price of gas, we still have to fill up our cars and trucks to get to work.
In our Inflation Kit, we use commodities based ETFs to gain exposure to these assets, and we use a sophisticated machine learning AI to allocate the right amount to them each week.
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