How to invest for higher inflation
Topping the worry-list for most investors these days is inflation.
How to combat inflation overall?
How to invest for higher inflation?
This post will share my thoughts including how I intend to fight higher inflation – inflation I expect to see for another year or so.
What is inflation? What does inflation matter?
What is inflation?
At the most basic level, inflation is an increase in the price of goods and services over time.
What does that mean for you and me?
An erosion of purchasing power…
How to fight this loss of purchasing power?
Well, here is one big idea from A Wealth of Common Sense.
In that post, Ben Carlson highlighted one of his favourite ways to combat inflation: the stock market.
“The stock market is a wonderful hedge against inflation for a few reasons. Since 1928, the U.S. stock market is up 9.8% per year while inflation has averaged 3% per year. So stocks have grown at nearly 7% more than the rate of inflation. One of the reasons for this is the fact that earnings and dividends also grow at a healthy clip above inflation. Over the past 93 years, earnings have grown at roughly 5% per year. Stocks also have perhaps the greatest income stream of any asset. Dividends have grown at roughly 5% per year.
So earnings and dividends both have a history of growing above the rate of inflation.”
Same thoughts here Ben. Complex problems can have some simple solutions. That said, things are more complex than that. It’s not just about investing in the stock market as one way to combat inflation. You might consider what stocks to invest in as a hedge.
Inflation is not all bad, is it?
Of course, you could argue some inflation is always very good. The economy is growing. Better than deflation. Deflation is associated with a shrinking economy and depressed times – less money in supply and therefore less money to spend.
- Inflation will hurt those who have a big bias to cash savings – should inflation continue.
- Retirees focused on only fixed income – they might suffer more.
- Borrowers who took on too much variable-rate debt or large sustained debt balances.
- Inflation will benefit those with modest debt who are on a fixed repayment plan over variable.
- Owners of land or scarce physical assets (like land, materials, other).
- Firms that can raise prices, rather easily, without too much trouble or public outcry, and more…
But spiking or high inflation is not good for many reasons and it really depends on your age, investment timeline and of course, what you invest in to combat inflation.
Let’s take a quick look at who needs to really worry about rising inflation in my book.
The Working Class (Inflation Worry Level: High)
As I mentioned above, with higher inflation or inflation spiking, that’s a challenge for the working class. Beyond higher prices at the grocery store or other, I believe this an issue because of the relationship between inflation and unemployment has traditionally been an inverse correlation. Low inflation and full employment are the cornerstones of monetary policy for our central banks. Inflation can cause unemployment when:
- The uncertainty of inflation leads to lower economic growth.
- Inflationary growth is unsustainable/not well-managed (see today), and
- Inflation leads to a decline in competitiveness, lower exports, etc. causing unemployment.
A decent argument can be made when higher inflation rates exist, unemployment will move higher. Countries like Germany have been fairly successful as a model: they have enabled a long period of economic stability to support a long-term low unemployment rate. If inflation increases however, monetary authorities will tend to increase interest rates to reduce inflation. A sharp increase in interest rates can cause economic growth to fall, potentially leading to a recession and higher unemployment. Therefore, we may predict that after any economic boom rising inflation could follow.
In some periods, we have seen both falling unemployment and falling inflation. For example, in the 1990s, unemployment fell, but inflation stayed low.
Personally, going-forward, I’m a bit concerned that inflation is running hot as a worker. I don’t believe my wages are going to go up tremendously in the years ahead and that means with higher inflation, companies are going to need to and will want to – cut back. If inflation continues to run hot, and our Bank of Canada remains sitting on their hands, I think we’ll see some company layoffs occur.
Aspiring retirees and retirees (Inflation Worry Level: Moderate)
Like I mentioned at the start of this post – topping the worry list for investors including aspiring retirees or current retirees?
Questions related to inflation abound.
- Do I have enough to retire, to fight inflation?
- Will I run out of money in retirement?
- How much can I safely spend in retirement?
Many aspiring early retirees or current retirees worry about the value of their investments that might not keep up with inflation. Add on long-term, future healthcare costs and there are larger concerns for any retiree to consider.
The good news is in my view, it’s not all doom-and-gloom. Here are ways retirees as investors can help fight inflation:
First, continue to own more stocks than bonds. Like Ben cited above, given stocks, historically, have been able to pass forward some rising prices back to the consumer, I’m going to continue to own my basket of stocks (including my dividend paying stocks) for the long-haul.
When thinking about how to inflation-protect an investment portfolio, it’s useful to consider the following key buckets:
- Inflation-hedgers, and
When I think of some inflation-hedgers I think of real estate and commodities in particular, although other sectors can “win” for sure.
Historically speaking, whether you are investing in real estate directly via your home, rental units, or owning publicly traded Real Estate Investment Trusts (REITs) – owning real estate can be a decent hedge for higher inflation. Why? Home values and rents tend to rise during inflationary periods. I mean, people have to live somewhere… Owners of apartment buildings, shopping malls, and other real estate tend to push rent increases at times when inflation is running up.
Better still IMO, I would also consider owning commodities and raw materials as inflation-hedgers. Commodities are a broad category of things like oil and gas, grains, electricity, and other. Commodities and inflation have a unique relationship as you well know. Rising commodity prices are indicator of (more) inflation to come. As prices rise, so does production/manufacturing costs to turn materials into commodities that are bought and sold. So, you can already see by this simple explanation how owning commodities might be helpful.
On the subject of gold, I personally won’t own it as an inflation-hedge due to it’s lack of effectiveness. See below. A long-term chart of gold against the CPI (Consumer Price Index). From the article I read “You might first notice that gold has risen more than the CPI, but also notice how little correlation there is between the two.”
Second, retirees should make good use of your government benefits.
When it comes to our Canada Pension Plan (CPP) and Old Age Security (OAS), you should know both government benefits have inflation-fighting power built-in. So, when you decide to take these benefits is a MAJOR retirement decision.
On Cashflows & Portfolios, there is an excellent article about when to take your CPP benefits.
- CPP at age 60 – If you begin your CPP/QPP payments prior to age 65, you’ll incur a 0.6% reduction for each month you collect before your 65th birthday. This reduction works out to be 7.2% per year. If you begin collecting your pension at age 60, your total reduction will be 36% when compared to age 65.
- CPP at age 65 – this is the “standard” age to take CPP without reductions or penalties.
- CPP at age 70 – If you don’t need the money, if you delay your CPP/QPP payments, you’ll receive an increase of 0.7% for each month you wait after your 65th birthday. This amounts to an increase of 8.4% per year and can be up to 42% if delayed until age 70.
The CPP is adjusted annually based on the consumer price index, which is intended to offset inflation.
So, delaying CPP up to age 70 is one the best, guaranteed, inflation-protection decisions you can make as a retiree.
You should know you can receive a higher Old Age Security pension amount for each month you decide to delay your first payment. While you can receive your first Old Age Security pension payment the month after you turn age 65, you can receive a higher amount for each month you decide to delay your first payment.
You can delay payment of the Old Age Security pension for up to 60 months (5 years) after you are 65 – up to age 70. The longer you delay, the larger your pension payment will be each month. Some Canadians don’t know this fact: by voluntarily deferring OAS benefits until age 70, Canadians can increase their OAS payments by 36%.
OAS payment rates are reviewed quartely in January, April, July and October to ensure they reflect cost of living increases, as measured by the Consumer Price Index (CPI). For example:
- monthly payment rates will increase if the cost of living goes up
- monthly payment rates will not decrease if the cost of living goes down.
So, be very mindful of when you take these government benefits to get the adequate inflation-fighting power when you need it the most, in your senior years.
Current investors in their asset accumulation years (Inflation Worry Level: Low)
As an investor striving towards semi-retirement in a few years, it’s not like I don’t think about inflation. I do, see this post today!
Rising inflation will likely hurt most growth stocks (think the tech sector) for example. But, as I have written about above higher prices can result in higher interest rates, which can lower the appeal of growth stocks compared to less risky alternatives, and make them a good time to buy.
If inflation continues to run hot, with a frothy broad stock market filled with 25% tech stocks like the S&P 500 is, I could see these tech stock prices coming down – fast! You could argue any tech risk in the S&P 500 is much higher now than in any tech bubble. So, buyer beware.
Back to my inflation-beaters comment, while I cannot predict the future, I continue to see value stocks in particular “beating inflation”, so it’s important to stay invested in these stocks during periods of higher inflation.
Beyond value in general, there are some sectors I really like or approaches I really like: companies with a history of increasing their dividends may provide a measure of inflation protection. So, this is part of the reason why I’ve always owned a basket of dividend-paying stocks in my portfolio. Dividend-paying stocks have historically demonstrated higher-quality and less volatility than the broad market.
When it comes to owning certain stocks in your portfolio, I would personally recommend you look at your exposure to growth stocks with higher inflation here – and not be “all in” on tech stocks like I mentioned above. Tech stocks in particular may perform poorly because they expect to earn the bulk of their cash flow in the future…as inflation rises, those future cash flows are worth less. This is not to say that will happen to those companies, but it could.
Check out how some U.S. equity sectors have performed related to inflation here:
Source: https://www.hartfordfunds.com/ – current graphic at time of post.
Based on my thesis above, you’ll find the following sectors should help fight or beat inflation:
- Consumer staples (think products you buy or use every day)
With inflation here, you may consider these approaches to generate retirement income.
I have no idea how long inflation climbs might be, at what level and when inflation might top out, what the impact inflation will or will not cause to our broader economy.
I would say as DIY investors we need to continue to embrace wealth builders and focus on what we can control: amount, time and rate of return. Added together, more money, more time to compound/grow and higher rates of return are ideal for us to combat inflation.
I would remain mindful but avoid obsessing about taxation or inflation in general. While unnecesary taxation should be avoided of course, inflation is something out of our control. It can be managed to an extent as we progress through our respective investing journeys.
Inflation is just one more reason why it’s important to have a well-diversified portfolio. If your investments are spread across different asset classes, geographies and sectors I think you (and I) can weather any inflationary storm. You should consider value stocks, dividend paying stocks, REITs and more to help you fight inflation. You should likely avoid keeping too much cash on the sidelines since current bank/savings rates of return are not likely to keep up.
Essentially, make sure you have a clear game plan for near-term expenses with long-term investment focus. I’ll keep you posted on my plan.
How are you fighting inflation? What are you owning? Are you simply cutting back spending instead? Do share in a comment!
Here are some lessons learned in my investing journey when it comes to diversification. I hope they can apply to you too!