Inflationary Assets

Inflationary Assets

Previously, we have went into what is inflation and its causes.

In this article, we will be going into the asset classes that perform in times of inflation.

Cash is Trash

Cash would always have 0% return. And especially in times of inflation, cash could be seen as having negative real return.

Investors holding onto cash would be losing purchasing power.

That is why, there is a need to look into asset classes that would outperform during inflationary times.

With that said, there is a still a place for cash in every diversified portfolio. It could be the ‘dry powder’ that provides liquidity when an opportunity (like a market correction) occur, allowing investors to buy at a discount. It provides flexibility to the overall portfolio.

In an even worse case scenario when the investor was wrong and deflation occurs instead. In this deflationary environment, cash is one of, if not the best performing asset class. Cash could act as a hedge against the inflationary assets that would underperform during deflation.

Real Estate

There are two ways that real estate could be a good investment during inflation. Rising rental income and appreciating house prices.

Rental cost is one of the main components of how CPI (link) is calculated. Residential rental accounts for a 24% weightage within the CPI as of 2018.

It is one of the main driver behind the perceived inflation and has in fact been outpacing inflation since the 1980s.

Residential Rent vs CPI Graph

Home prices would also tend to appreciate during inflation. Acting as a store of value.

Home prices also tend to appreciate more than inflation.

Some ways to invest into real estate could be through REITs or owning an extra property.

However, one thing to note is that the housing sector in general tends to be very sensitive to interest rate.

When interest rate goes up, so would mortgage rate. This might put downward pressure on home prices as more homeowners default on mortgage loans.

It might also be possible for rental income to go up in such a situation as homeowners look a temporary lodging after losing their home.

Or, it might be possible that these homeowners instead look for lodging in rural areas.

Commodities

Similar to real estate, commodity prices are also one of the primary drivers behind CPI.

By investing into commodities, it would be akin to staying ahead of inflation.

“Because commodities are real assets, they tend to react to changing economic fundamentals in different ways than stocks and bonds, which are financial assets.”

Financial assets’ price would fluctuate based on speculation, interest rate and news.

Commodity prices on the other hand is controlled by the real economy.

Commodity prices are not dependent on factors like time value of money as they are physical products. They are not priced based on future earnings. They are controlled by demand and supply of the goods.

This is also why they perform very well in times of rising inflation. The rise in interest rate in such an environment does not affect them adversely (or even at all).

Furthermore, they are shown to be relatively uncorrelated to stocks and bonds, adding further diversification across asset classes.

Stocks

Stocks are priced with regards to their future earnings. That is why an increase in interest rate caused by rising inflation would cause stock price to fall.

When interest rate increases, the future earnings of the stocks would be discounted more heavily to the current value, causing a dip in the prices.

Stable inflation is what benefits stocks as money would continue to flow into the financial system. Especially in an environment where yield on bonds had been on a downward trajectory for 40 years, stocks and bonds had been performing very well in this environment.

Traditionally, bonds and stocks had been the 2 main asset classes in a portfolio. However, yield on bonds had been so low that it encourages more funds to be pumped into stocks.

The return on bonds had been too low to justify a significant allocation to it.

 

Below is my outlook on the stock market and investors’ psychology. I would be side-tracking from the article’s original intention as I think that it is important for investors to understand the risk behind the stock market.

 

In recent decades, the Federal Reserve had been stepping in to prop up the market every time is crashed. The narrative now has been that over long period (5+ years), the stock market would always have a positive return.

It seemed that most investors had forgotten about the great depression in 1929. Although the crash ended in 1932, it took the stock market more than 20 years to recover to its all-time-high.

Perhaps some investors would look at that event as a rare occurrence that would never happen again. After all, it is an event close to a century in the past. It is too distant for investors to relate to.

So, let’s look at a more recent event where the stock market underperforms for an extended period of time.

Japan’s Lost Decade. At this point, the name is not accurate. It has been more than 20 years since the crash and the stock market (Nikkei 225) has yet to recover to its all-time-high.

Nikkei 225 Graph

Furthermore, the situation between the Japan’s Lost Decade and US today is worryingly similar.

Interest rates are near zero-bound. This encourages investors to hold onto cash instead of bonds as there is little upside to bonds.

This increases demand for cash. Yes, demand for cash.

This strengthen the currency relative to foreign currencies. This encourages more investors to hold onto cash.

Consumers and businesses would reduce spending and investment, preferring to hold cash instead.

As spending declines, the economy would slowdown and deflation would become more of a possibility.

And in such an environment, there is little that monetary policy (policies regarding interest rate) could do. 

Interest rate being near zero-bound there is not going to be much effect lowering it.

Rising interest rate on the other hand would promote investment into bonds, but not spending. It might even discourage spending.

 

My two cents are that investors best not be too heavily positioned for inflation. The opposite could very well happen.

Diversify into positions that is a complete opposite from your economic outlook. If you believe heavily in inflation, have a smaller allocation as a deflation hedge.

It is often what investors did not account for that wipe out the portfolio. Be prepared for what you think is unlikely.

Gold and Bitcoin

Gold doesn’t perform particularly well in stable low inflation nor in rising inflation.

Gold could be seen as the last defender of a portfolio. A hedge against fiat devaluation (hyperinflation). A good example would be Weimar’s Republic’s hyperinflation where the currency was devalued heavily.

Weimar Republic Currency
Source: Wikipedia

When people think of hyperinflation, they tend to think of burrows of cash used to buy just a loaf of bread. It is a story that propagates easier as it has a shock factor.

However, before the hyperinflation (exponential part), the currency had already been devalued heavily. From 1918 to 1920, the Mark had lost more than 90% of its purchasing power. The hyperinflation merely made matters worse by devaluing the remaining 10%.

In such an environment, any investment that is dependent on the strength of the currency fell apart. It didn’t matter how much price appreciation the investment had if at the end of the day, the currency is growing more worthless by the day.

Investors would be in a panic and the flight to a safe haven would occur. The funds in stocks, bonds and other assets would flow into gold as they look for an asset that would protect their wealth.

Why gold?

Gold is limited by its scarcity, it is a currency that could not be devalued by entity.

But most of all, it has a track record of retaining its value over 4,000 years while other forms of fiat have come and gone.

Unless proven otherwise, investors would continue to treat it as a store of value which in itself gives it value.

 

There is also a rising competitor, Bitcoin. Digital gold is what some would call it.

It has very similar properties as gold, mainly that its also limited by scarcity. However, there is a problem with regulation that might make it more volatile than gold.

As of writing this article, India had outright banned Bitcoin. Not allowing its citizens to possess it.

However, as Bitcoin gain institutional adoption, there will be more opposition towards the banning of Bitcoin. By growing in size, it would be harder for countries to regulate it.

I have very positive sentiments towards Bitcoin and cryptocurrency. I would probably write a dedicated article towards them in the future.

Conclusion

  1. Stable (Low) inflation
  2. Rising inflation
  3. High inflation

Personally, I tend to see inflation as types. After all, different inflationary assets perform differently in different inflationary environment.

This is a summary of the previous points.

Stable inflation is good for stocks.

Rising inflation is good for commodities.

High inflation is gold and maybe Bitcoin.

Real estate is more flexible and could perform or underperform.

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