ATTENTION: Inflation

The financial press has been talking about inflation quite a bit during the last few months. Indeed, inflation for the 2nd quarter was over 5% and in Bloomberg’s latest survey of economists inflation is anticipated to be well above the Federal Reserve’s 2% target for several years. While there was a belief that the current high level of inflation would be transitory as supply and demand in goods markets and along supply chains balance, that belief is quickly fading.

From the perspective of managing financial assets, the question is how to invest during periods of inflation. In this article, we will talk about the three broad categories of investment assets and analyze which ones are safe to hold during periods of high inflation. 

First of all, we need to define the two major channels through which long-run price increases can occur. The first is inflation, and it simply means that one’s purchasing power in a certain currency is decreasing. For example, if inflation in dollars is increasing, a dollar becomes less and less valuable. In this scenario, the price of a barrel of oil will increase in price simply because the currency being used, a dollar, purchases less and less; so one has to spend more and more dollars to purchase the same barrel of oil. In this case, we say that the purchasing power of dollars is decreasing because each dollar buys less. The second channel is simply market supply and demand relationships. For example, if the demand for a good such as renewable energy increases while demand for oil decreases, then if the supply of neither changes, the price of renewable energy per unit will increase, and the price of a barrel of oil will decrease.

In our investment analysis, we will try to isolate the effects of the inflation channel for price increases, and hold everything in the supply/demand channel fixed, though there will be some interactions between the two.

Let’s first consider investing in fixed income instruments, such as US government bonds. Virtually all bonds aside from inflation-protected bonds pay a fixed dollar amount of interest per annum and a fixed dollar amount of principal at maturity. It is easy to see that if the value of a dollar is decreasing (i.e., the purchasing power of a dollar is decreasing), then the price of all dollar-denominated bonds will be decreasing. This is because the purchasing power of every cashflow from the bond is decreasing, so the purchasing power of the aggregate cashflows from a bond will also be decreasing. 

So, owning fixed income instruments is a bad idea during inflationary periods. The only exception is inflation-protected bonds. With these bonds, rather than fixed dollar cashflows, all of the cashflows of the bond are indexed to inflation. As a result, inflation-protected bonds are not subject to inflation as a risk factor. However, during periods of high inflation, the demand for inflation-protected bonds increases dramatically. In addition, the supply of inflation-protected bonds is fairly limited. As a result, in periods of high inflation, inflation-protected bonds are very expensive. For example, the 10-year inflation-protected Treasury has a yield of about -1% currently (yes, that’s a negative interest rate). Essentially, investors are so desperate for inflation protection, they are willing to pay rather than receive interest in order to have that inflation protection.

Let’s now take a look at the impact of inflation on equities. The common thinking is that equities go down during inflationary periods. However, the data says otherwise. While there may be some short-term drops in equities, over the long-run stock prices go up during periods of high inflation. Let’s take a look at why.

Inflation can impact stocks in many different ways. First, a share of stock has a price that is dollar-denominated. So, when inflation weakens the purchasing power of a dollar, it takes more dollars to buy the same share of stock, i.e., the price of the stock will increase. That’s the macro view of inflation’s effect on stock prices. Let’s also do a microeconomic analysis of this. Fundamentally, a stock price is determined by a company’s future profits. Profits are defined as revenues minus expenses. So, consider a company with revenue for the coming year expected to be $100M and expenses expected to be $80M. The company is therefore expected to make $20M in profits for the coming year ($100M - $80M). Suppose inflation ends up 10% higher than expected. This results in a revision of expected revenues and expenses. Revenues will be 10% higher because 10% inflation will allow the company to charge 10% more on its goods. However, expenses will be 10% higher as well because the company’s vendors will charge the company 10% more for raw materials, and workers will also demand 10% more in wages to cover the higher costs of goods they purchase and consume. So, 10% higher revenues result in $110M in total expected revenue, and 10% higher expenses result in $88M in total expected expenses. Thus, expected profit will be revised to $110M - $88M = $22M. This is 10% higher, which is precisely the increase in inflation, and therefore the company’s stock price should be 10% higher as well. So, inflation will cause profits to rise at the rate of inflation, which in turn will cause stock prices to rise at the rate of inflation as well.

The above argument is actually an argument for long-run stock price impact. In the short-run, a number of other factors come into play. Depending on the leverage the company has over its vendors/workers, its customers, and its competitors, higher prices may not get passed along as quickly as described in the example above. For example, Apple has a huge degree of leverage over vendors in its supply chain and so it may be able to prevent its vendors from passing along price increases immediately. So, Apple may not feel the impact of higher expenses right away, and therefore, Apple may be able to achieve marginal profit growth at a higher rate than inflation in the short-run. However, eventually those vendors will pass along price increases to Apple, and Apple’s long-run marginal profit growth will revert back to the rate of inflation.

In summary, equities are a good asset class to hold as an inflation hedge in the long-run. In the short-run, there may be stock volatility as goods/labor price increases are passed through the economy at different rates. However, in the long-run, all stock prices should increase faster if a higher rate of inflation occurs. Therefore to protect against both short-run volatility and long-run inflation, it is important to hold stocks both vertically and horizontally, i.e., at all vertical levels of the aggregate supply chain up to the consumer, as well as across companies in a given industry, as well as across multiple industries.

Finally, let’s consider commodities. Long-standing wisdom touts commodities as a crucial holding to hedge inflation impacts. Indeed, as we showed above in the example of a barrel of oil, as the purchasing power of a dollar weakens in the face of inflation, it will take more and more dollars to purchase a fixed unit of commodity such as a bushel of corn or an ounce of copper. Therefore, in general the prices of commodities will increase in terms of the currency experiencing inflation. However, it is important to realize that commodities can experience the greatest short-run supply/demand imbalances. For example, only so much copper can be mined from the earth in a given period of time. Or, companies and/or countries may collude via cartels, such as OPEC, to limit supply of commodities. So, commodities are a good hedge against the impact of inflation, but there could considerable short-run volatility in commodity prices, even more so than with equities. Again, the best way to protect against short-run volatility is to hold a variety of commodities.

We can hold commodities directly by purchasing commodity futures contracts or purchasing shares in a fund that holds these contracts. Alternatively, we can realize that commodities are basically at the lowest rung of the supply chains that span the globe. So, as long as we are holding equities vertically at all levels of the supply chain, we will have commodity exposure in the portfolio. To get a bit more commodity exposure, we can simply over-weight equities in those companies at the bottom of supply chains.

In summary, if inflation is a major concern, it is important to first substantially reduce fixed income positions in the portfolio, second substantially increase equity exposure, and finally somewhat increase commodity exposure. Additionally, to protect against short-run volatility in equities and commodities due to the differing rates at which various prices will increase as inflation flows through the economy, it is important to diversify vertically and horizontally.