Inflation has been a front-and-center topic in recent months, mostly because it’s been moving higher. Consumer prices (CPI) rose 5.4% in July 2021 from July 2020, which marked the highest 12-month jump since 2008.
There was one silver lining in the CPI fine print, however – inflation rose at a 0.5% pace from June to July, which marked a material slowdown from the 0.9% increase from May to June. Even still, the average pace of increase was 0.2% from 2000 to 2019, so inflation is currently moving twice as fast in 2021 as compared to previous decades.1
It’s still up for debate whether inflation will ultimately prove “transitory” as the Federal Reserve believes, or whether inflation could be stickier. In either case, investors would be well served to understand what types of investments could serve as effective inflation hedges, and which ones don’t. Here are three factors to consider.
- Why Stocks Have Historically Been Good Inflation Hedges
To understand why quality stocks have historically been good inflation hedges, consider a hypothetical example involving Coca-Cola.
Let’s say sticky inflation drives up the prices of syrup, cans, and labor, all of which increase the cost of producing one can of coke. Rising costs theoretically hurt Coca-Cola’s bottom line, unless they raise the price for a can of coke – which they will. Coca-Cola has pricing power, meaning they can raise the prices of their product without driving away significant numbers of customers. In this way, pricing power gives companies – and shareholders – the ability to maintain profits even as inflation goes up.
Investors may also want to consider the distinct possibility that value stocks may hold up better in an inflationary environment than growth stocks. The reason why, in my view, has to do with earnings. Growth stocks’ earnings are generally further out in the future than value stocks’ earnings, meaning the present value of those future earnings is more sensitive to higher interest rates (which are often driven higher by inflation). That’s why in the past I’ve warned readers that the possibility of rising interest rates in the coming quarters and years are likely to impact high valuation stocks, like Tech shares.
- Gold is Often Considered to Be a Solid Inflation Hedge. But Is It?
For decades, it has been a popular view that gold is a reliable and effective inflation hedge. The data simply doesn’t support it, though.
A recent study by some economists at Duke University looked at the ratio of gold to the consumer-price index over long periods. If gold was a reliably good inflation hedge, the ratio between gold and the CPI should have remained relatively steady over the years. It didn’t – over the past 50 years, the ratio of the price of gold to the CPI has fluctuated from 1.0 to 8.4, indicating fairly wild swings and dismissing the notion of ‘reliable.2
The researchers concluded that gold has done a relatively good job of maintaining purchasing power over a time horizon that’s much longer than anyone actually lives – a century or more. If you consider shorter time frames like a few decades, however, gold’s inflation-adjusted price fluctuates just as much – if not more – than other risk assets.
Then there’s the bottom line, which is long-term total return. Since 1971, the S&P 500 has generated an annualized return of +11.2%, while gold has delivered a significantly lesser +8.2%. If you strip out the decade following President’s Nixon announcement that dollars could be converted to gold at a fixed rate – which was the decade where gold performed the best – stocks annualized +12.2% compared to just 3.6% for gold. Even Treasuries did better, at +8.2%.
- With Bonds, It’s Important to Be Active
Finally, there are bonds to consider. In an inflationary environment, an investor who holds bonds to maturity gets paid back what he/she lent a borrowing government or company, and those dollars are almost certain to have less purchasing power five, ten, or 30 years later. What’s more, an inflationary environment will produce higher interest rates, and rising rates mean falling bond prices – not great for investors.
This is not to say that bonds are outright bad for inflationary environments. It just means that investors need to actively manage their bond portfolios to ensure their total return and income needs are constantly being addressed.
Bottom Line for Investors
It remains unclear how impactful inflation will be in 2021, but it makes sense for investors to think about what type of inflation hedges may work in portfolios. As I’ve detailed above, stocks are not immune to inflationary conditions, but they have historically done the best job – in my view – of consistently delivering returns needed to maintain pricing power over time.