As we approach the middle of 2022, we’re continuing to see a major economic theme play out in economies all around the globe: hefty inflation figures, not seen in several decades, are continuing to play out everywhere. Here in the US, the Consumer Price Index (CPI), a broad-based measure of the price of goods and services in the economy, recently rose at an annual rate of 8.6%. This lofty figure was at a level not seen since December of 1981. Most economists like to ‘strip-out’ or exclude volatile food and energy costs in determining inflation. This figure, called ‘Core CPI’ was still up 6% during this same time period. Both of these figures were above analyst expectations.
Technically, what is inflation? Most people view inflation as being a rise in prices, but you can also lump a declining value of money into the definition. Whether you believe inflation is transitory from the Covid pandemic, is in part temporarily due to the conflict in Ukraine or it’s something more prevalent and here to stay, this article will focus on how high levels of inflation can affect the return on various investment portfolio components. Amongst other asset classes, a diversified investment portfolio will consist of stocks and bonds, but also commodities and real estate. We will focus on these components during our inflation discussion.
For the majority of investors, their heaviest portfolio component will often be in equities (common stock). Essentially, a common stock price is the value of a company’s future earnings brought back to the present day. In general, a moderate level of inflation (2-3%) is actually conducive to stock prices because it indicates that the economy is running at trend levels and not overheating. However, when higher, unexpected inflation ‘surprises’ turn up, stock prices can be hit exceptionally hard. The level of share price impact can depend how easily a firm can pass price increases on to consumer, the company’s level of debt and their current profitability.
Inflation impacts firm profitability in several ways. The first is that a firm is forced to pay higher input costs in their production process. Unless the firm is in what’s called the ‘consumer non-discretionary’ sector and faces what is called ‘inelastic’ demand for their product (a company like Proctor and Gamble or Gillette who make hygiene products that everyone needs), it’s difficult to pass price increases on to consumers. This is why companies in the ‘consumer discretionary’ industry who have an ‘elastic’ demand for their product (a company in high end retail like Victoria Secret or luxury automobiles like Tesla) tend to see their earnings suffer more during higher inflationary periods as consumers shun their products. When company earnings decline, their stock price tends to follow suit.
Next, a company’s level of debt can have a significant impact on their share price performance during high inflationary periods. Corporations typically issue bonds in order to raise money to invest in capital expenditures or mergers and acquisitions. However, significantly higher inflation can result in significantly higher interest rates as central banks raise rates to cool the economy. This can make it much more expensive for companies to refinance their existing debt that is coming due or to raise new money. This is particularly true of smaller, riskier firms (in what’s called the ‘high yield’ category) where borrowing rates can bolt even higher. Simply put, higher debt payments result in higher interest expense on the income statement, less profit, and lower stock prices.
What has been particularly fascinating over the course of 2022 is how quickly and hard the share prices of many small to mid-size technology stock prices have fallen. Companies like DocuSign, Snowflake, Okta, Twilio and a host of others have all plummeted 70% or more due to the spectre of higher inflation, which brings along higher interest rates. These companies are currently not profitable and may not be for several years. As such, when their earnings streams (which are farther out into the future) are brought back to today through the process of ‘discounting’, this figure is discounted at a much higher rate. As we know, heightened inflation expectations have forced central banks to increase rates.
During periods of unusually high inflation, the portfolio component that is likely to be the sure loser are bonds (with the exception of inflation protected bonds). The reason here is fairly straightforward: bond coupon payments are fixed over the life of the bond, as is the final terminal principal payment. As such, high inflation tends to erode the purchasing power of these fixed payments over time. To make matters even worse, during periods of rampant inflation central banks are often forced to increase interest rates which can greatly impact the market value of a bond. As new corporate and government bonds (‘on-the-run’ bonds) are issued with higher rates, the market value of older bonds circulating through the economy (‘off-the-run’ bonds) tend to decrease in price to make up for their yield differential.
However, there are two types of US federal government-issued bonds that can actually benefit investors when inflation is high: those are, I-Bonds and Treasury Inflation Protected Securities (TIPS). I-Bonds have an increase in their semi-annual stated interest rate that is linked to the Consumer Price Index for All Urban Consumers (CPI-U). This bond is purchased directly from the Treasury Department in denominations of $10,000 for a term of 30 years, though can be redeemed early with no penalty if held for a minimum of 5 years. The most current I Bond interest payment in May of 2022 comes with a very healthy 9.62% rate, where the variable inflation component is adjusted every 6 months.
Treasury Inflation Protected Securities (TIPS) on the other hand, do not have an interest rate that fluctuates directly with inflation. Rather, the principal amount is adjusted by an inflation factor (also the CPI-U) which is then multiplied by the stated bond interest rate. This calculation is done every month. What’s interesting is that investors are able to receive the inflation-adjusted principal upon redemption. Unlike I-Bonds, TIPS can be purchased through an investment fund, like a mutual fund or exchange traded fund that specialize in TIPS investing. Two great products for TIPS exposure managed by professionals are the Vanguard Short-Term Inflation-Protected Securities ETF (VTIP) and the iShares TIPS Bond ETF (TIP).
When it comes to real estate, the most common holding for individual investors to get portfolio exposure are through real estate investment trusts (REITs). REITs are investment companies (like a mutual fund or exchange traded fund) that own and/or operate physical properties like office buildings, shopping malls, apartment complexes and even warehouses. They are required by law to pay out 90% of their income to investors in terms of dividends. During periods of unusually high inflation (inflation above 7%), REITs tend to perform very well, even outpacing stock market returns in the US. In fact, just as recent as 2021, the US REIT market outperformed the S&P 500 by 12.6%. The reason for this outperformance is two-fold.
The first is that property owners are able to increase their rent or lease payments during high inflationary periods. This is because the economy is usually growing at a rapid clip and tenants, whether it be individuals or business owners, are willing to pay higher prices. Operating performance generally keeps pace with inflation, and long-term leases have inflation protection built-in, and shorter-term leases are based on current price levels. The second reason REITs do well in periods of high inflation is that property values tend to increase along with price levels during inflationary times, providing an additional return to investors.
The big portfolio winner during periods of unusually high inflation are commodities. However, this depends on the type of commodity and how it is held. Commodities are things like gold, oil, natural gas, corn, wheat and coffee. Commodities can be invested in in a variety of ways, whether it be commodity futures, a broad-basket of diversified commodities in a mutual fund or ETF or by purchasing shares in actual companies that produce a commodity. However, one must be careful in how their portfolio is positioned with respect to commodities during excess-inflationary time as not all commodities respond to inflation the same way.
For the sake of this article, we will discuss a ‘pure-play’ on a commodities, that is, how the actual physical commodity performs during these high inflation periods. Energy prices (crude oil, natural gas, gasoline) have had the strongest correlation with inflation over time, as oftentimes an increase in energy costs results in inflation due to the prevalence of energy components across the economy. Many individuals feel that gold fluctuates directly with inflation, but this tends not to be the case. Gold over time has had its greatest increase in price during periods of economic strife, when investors flock to the yellow metal for safety. The agricultural sector, while showing some correlation with inflation over time, can be at the whims of weather-related disruptions that can affect prices.