How to survive and thrive in a world of rising prices
Noticed what’s happened to the price of milk lately? Bread? Chicken? Or pretty much anything else? Of course you have. Over the past year or so, the prices for everything in the grocery store – and the shopping mall, and the gas station, and the local restaurant, and almost everywhere else – have gone through the roof.
Some economic analysts believe that this soaring inflation is a temporary phenomenon: once we move past Covid-sparked supply chain issues; once the war in Ukraine winds down; once the U.S. Federal Reserve fully exits its quantitative easing program; and so on, inflation will settle down to more moderate levels in and around 2% per year. Others believe the opposite: that we’re living in a new era, one in which prices will keep rising for the foreseeable future.
Which perspective is correct? And if we are, indeed, headed toward a “brave new world” of inflation, how will this affect your portfolio? How can you adjust, trim, reallocate and reposition your existing portfolio to survive inflationary pressures, while identifying and seizing the opportunities that this new inflationary world presents?
How inflation “happens”
Before we answer those questions, let’s take a closer look at what exactly inflation is. A simple working definition is that inflation is the name that economists give to a phenomenon with which we’re all familiar: the prices for goods and services increasing over time, typically expressed as a percentage increase year-over-year. Or, to look at it from the opposite perspective, if the prices of goods and services are increasing, then the “value” of a dollar (i.e., how much that dollar can purchase) must be decreasing; in this way, inflation is a measure of how much value a dollar has lost in a given 12-month period.
For everyday consumers such as you and me, it often seems that inflation just “happens” – that it’s natural for the prices of things to rise over time, because … well, that’s just what prices do. But economists know better; inflation usually has very specific causes, and most of those causes are fairly easy to understand:
Supply shortages are one example that we’ve been experiencing since the onset of Covid-19. When factories around the world are shut down, there will be fewer products to buy in stores. So the prices of things that are still available tend to move up.
Closely related to the above is demand shock. If, for example, everyone suddenly wants to buy a used car (something else we saw during Covid), you can bet that the prices of used cars will increase.
A sharp rise in input or production costs is another reason for inflation. Say that the price of oil spikes sharply because of a war in a major oil-producing nation (such as Russia). Expect to pay more to fill up your tank.
Money policy can have a dramatic impact on inflation. If a government cuts taxes or a central bank lowers interest rates, businesses and consumers will have more money to spend, which can cause prices of certain assets to go up (housing is an example here).
Since the financial crisis from 2007-2008 to about 2021, inflation rose very slowly in Canada – about 1.7% a year. However, starting in 2022, inflation jumped sharply, touching a high of 8.1% in June of 2022. Looking back, we can see that the spike was because several inflationary pressures were occurring all at once. Supply of basic goods was curtailed because of Covid-19-related shutdowns, so demand increased. As we moved out of Covid-19 lockdowns, input and production costs (including labour costs) went up, at the same time as many central banks were raising interest rates. All of this has created something of a “perfect storm” for inflation.
How inflation affects your portfolio
If inflationary pressures are present for a short time, markets and the economy can usually adjust without too much trouble. But when inflation persists for months or years, it can significantly erode purchasing power. And that’s not only a problem for your weekly grocery bill, but for your investment portfolio as well. Here’s how:
Bonds and fixed-income investments – Rising inflation has the most serious effect on bonds and other fixed-income investments, because inflation erodes the purchasing power of a bond’s interest payments, which are usually set at the time of purchase. The longer the term of the bond, the more it is affected.
Stocks – As a whole, stocks tend to hold up fairly well against inflation, largely because a company’s revenues and earnings should (in theory) increase at a similar pace as the price of the goods and services which other companies sell. Of course, that’s only a general rule; the performance of individual stocks during inflationary times can vary widely, as some businesses are affected by the forces of inflation more than others.
“Hard assets” – Broadly speaking, the value of real assets (industrial metals, agricultural inputs, gold, real estate, etc.) usually rises with inflation. The companies associated with the production of these hard assets (miners, fertilizer stocks, infrastructure owners and real estate businesses, etc.) will tend to do the same.
If current high inflation levels drop quickly and return to the Bank of Canada’s target level of about 2.0% per year, then none of these need be a disaster for your portfolio. But most economists currently expect that, over the next several years, we’re likely to experience continuing inflation pressures, with the average rate of inflation higher than what we’ve been used to over the past decade.
Fending off inflation: investment ideas to consider
Periods of high inflation (or even rapidly fluctuating inflation) demand a somewhat different approach to portfolio management than times at which inflation is benign. Here are some ideas that can help you buffer your portfolio against inflation’s effects:
Commodities are the raw metals, materials and industrial goods used to create the products which we buy every day – minerals and metals, lumber, agricultural goods, crude oil and many more – the starting “ingredients” that many businesses use to manufacture these everyday goods.
Because they are largely uniform products constantly traded in bulk all over the world, commodities tend to react fairly quickly to changing economic conditions. As demand for goods and services rises, for example, the value of the commodities that go into making those goods and services tends to rise too. (In fact, in many cases, the rise in the prices of basic commodities can be the trigger of inflation, causing prices to increase all along the manufacturing chain.) Of course, the opposite is also true: when inflation moderates, commodities and the businesses that produce them can often feel the pinch quite acutely.
This ability to keep pace with rapidly rising prices can make for a compelling investment during times of high inflation. Holding commodities (or shares of commodity-producing businesses) can often help to offset the negative impact of inflation on other parts of a portfolio. Just keep in mind that commodity investments can be notoriously volatile – when inflation recedes, commodities often drop in value, and often quickly.
As a physical “hard asset,” the price of real estate tends to keep pace with the overall cost of living. That’s largely because the cash flows from real estate assets can be adjusted in response to inflation – landlords can increase rents. Because the value of a given property is usually calculated as a multiple of the rent that can be realized from it, the principal value of a real estate asset usually holds up pretty well during inflationary times.
This isn’t a hard-and-fast rule, of course. Residential home prices can certainly suffer a drop if interest rates increase rapidly and demand slows (such as is happening now). As income property owners know, property taxes, maintenance costs and the price of home repairs tend to rise during inflationary times – and this can certainly affect the value of rents and erode the value of a given property. Different economic forces can affect sub-sectors of the real estate market very differently: the price of office real estate, for example, is currently under pressure because of the dramatic shift toward many people working from home in a post-Covid world.
A lot of us are already exposed to real estate by way of home ownership. If you’re interested in adding more, direct ownership of a rental property is always an option. For those seeking increased diversification, a real estate investment trust (REIT) can be a good choice. Keep in mind, however, that many REITs have been impacted by rapidly rising interest rates, so make sure to do your research (or hire a professional ETF or mutual fund manager to do it for you) before you jump in with both feet.
Like all metals, gold, silver, platinum and palladium have a variety of real-world uses such as in jewellery, electronics, auto components…even as dental fillings. But their primary use is financial. They are considered to be stores of value, primarily because investors perceive their worth as somewhat unconnected to the goings-on in the broader economy.
In practical terms, this means that precious metals have a negative correlation to broader stock and bond markets; their price tends to rise when these other asset classes fall or, at the very least, fluctuate independently of major market moves. The history of gold is instructive here: during the last major inflationary period in North America from 1973 to 1979, inflation averaged about 8.8% south of the border. Over that time, gold posted a 35% annual return. If inflation remains high for an extended period, many market watchers expect gold to do equally well.
Does this mean that you rush out and start burying gold bars in the backyard? Not exactly – gold’s recent history as an inflation hedge has been much more inconsistent than its historical record would suggest. Precious metals can also be highly volatile, which makes them less than ideal for conservative investors. And, of course, a gold bar doesn’t generate any income for you during the time that you hold it.
However, if you’re concerned about persistent high inflation over the next several years, buying physical gold via an ETF that holds bullion might be something worth investigating. For seasoned investors willing to take on more risk, the stock of well-established, conservatively managed precious metals miners could be another option.
In times of high inflation, regular run-of-the-mill bonds tend to take it on the chin. And that’s because inflation can significantly erode the interest which a bond pays after accounting for inflation (typically called a bond’s “real return”). The longer the bond’s term, the more that erosion can impact investors.
A simplified example will clarify the danger. Imagine that you purchase a five-year government bond that pays, say, 5% interest a year. At the time you purchased it, inflation wasn’t a big concern, at just 1% a year. This means that in the first year, you earn a real return of 4%. In the second year, however, inflation spikes to 5%. Suddenly, your bond isn’t earning anything at all: yes, you still collect your 5% interest payments, but the purchasing power of those payments is being eroded by the same amount. And, if inflation creeps even more, you could actually be losing money in purchasing-power terms. Not a very attractive prospect.
Inflation-indexed bonds offer a potential solution to this problem, with interest payments (and usually their principal, too) adjusted to keep pace with the rising cost of living. That provides fixed-income investors with a degree of much-welcomed certainty when inflation erodes the purchasing power of other fixed-income investments.
Inflation-indexed bonds are usually offered by governments, and can vary in name and features according to the issuing country. In Canada, Real Return Bonds are offered by the Canadian government; such bonds adjust both their principal and their interest payments semi-annually with the national inflation rate. For U.S. investors, the interest payments on Treasury Inflation-Protected Securities (TIPS for short) are reset every month, offering even more protection. If you’re an investor with a significant portion of your portfolio in bonds, it might be a good idea to investigate these options.
Rapidly rising prices are rarely good for any business. But not all businesses suffer from them in the same way. In fact, the stocks of some high-quality businesses are largely resistant to the effects of inflation – and some actually benefit from it.
Basic household goods such as toothpaste, paper towels and dish soap – we purchase these regularly regardless of inflation. Groceries and gasoline are the same. Ditto for health care – if you’re sick, you’re going to get that prescription filled, no matter what economists may be saying about inflation. Sure, we might tighten our belts and try to cut back on these expenses when prices are rising, but very few of us are going to completely stop buying these things, which is good news for the companies that provide such essentials. This doesn’t mean that these businesses are completely immune to inflation. But when you run a business from which consumers will keep on buying despite rising prices, that bodes pretty well for your stock price.
Focusing your portfolio on a handful of these companies can be a good way to insulate yourself from some of the market turmoil brought on by inflation. Obviously, the best time to do this is before inflation becomes an issue. But such investments aren’t a bad idea even now – particularly if the economists are right, that inflation will be with us for at least a few more years.
We’ve been big champions of blue-chip, dividend-paying businesses for a long time – they remain a foundation of a solid retirement portfolio, and almost every snowbird would be well-served by allocating at least a portion of their portfolios to them.
During times of inflation, however, dividend-paying stocks can be an even better idea. Not only does their size tend to make them less volatile than more speculative “hot stocks,” their regular dividend payments can compensate for at least some of the loss of purchasing power caused by inflation. Plus, most dividend-paying companies slowly increase their dividends over time, even during times of high inflation – the higher prices which they charge for goods and services generate more cash to pay out to shareholders. That makes dividend-paying stocks dramatically different from bonds, for example, whose interest payments are often (although not always) set at the time of purchase.
Is it a good time to add solid, dividend-paying stocks to your portfolio? Again, the best time to do so was before inflation kicked into high gear. But they can still be a good choice going forward. Many large dividend payers in sectors such as telecom, health care, railroads, consumer staples and select banks can insulate your portfolio against inflation. For those investors who aren’t the stock-picking type, dividend-focused ETFs and actively managed mutual funds offer a way to get broad diversified exposure to dividend stocks in a single affordable investment.
Economically, we live in a world in which economic and political events on one side of the globe can (and frequently do) affect markets on the other side. We saw this during Covid: supply chain issues in China, lockdowns in Europe and vaccine problems in North America all resulted in market turmoil, no matter where you invested your money.
But that’s not always the case. Sometimes, world economies diverge and this seems to be the case with inflation: it looks to be going higher in the United States, but seems to be coming down (albeit slowly) in Canada. It’s exceptionally high across much of Europe (thanks in large part to the war in Ukraine) but it’s rather muted in Japan and China. In some emerging markets, it’s running hot but, in others, it’s not really much of a concern at all (at least at the moment).
If you’re concerned about how inflation in North America will punish your portfolio, perhaps it’s time to consider some geographic diversification. Carefully selected exposure to stocks and bonds based in inflation-resistant geographies can be a good way to minimize inflation’s effects on your North American holdings. For most investors, a global or international-focused ETF or mutual fund is probably the easiest way to gain such exposure; more experienced investors might want to take a look at country-specific ETFs or even individual stocks listed on foreign exchanges.
Inflation has a broad impact on the whole economy all at once. But that effect isn’t always reflected in the prices of every investment – particularly when there are other issues and challenges on which investors are focused.
This is especially the case for certain stocks in companies that are undergoing fundamental change. Mergers and takeovers, spinoffs, initial public offerings, turnaround stories, companies with significant operational challenges that are slowly being solved – sure, all businesses will be affected by inflation. But when it comes to their stock price, the event that’s driving change will usually matter more. If a company can come through that change successfully, it’s likely that success will move the stock price higher, in spite of high inflation.
Keep in mind that searching for such opportunities is best suited to veteran investors not afraid to roll up their sleeves and get into the weeds with detailed stock analysis. If you’re a “set it and forget it” type of investor who’s more interested in pursuing your interests than poring over company reports, it’s probably best to leave this area alone. Special situations can be volatile (if the expected event doesn’t happen, or doesn’t happen as expected, chances are that the stock price will fall quickly). They require a lot of research and ongoing attention. And, perhaps most of all, a strong stomach for risk.
A final word on inflation…
No doubt you’ll be hearing a lot about inflation in the coming months. And some of what you hear will likely be disheartening or even downright scary, with discussion centred around all of the negative impacts which inflation has on the economy, on the stock market and on other aspects of our society.
But that’s not the best way to think about inflation. At its most basic, inflation is simply a change in the environment in which we make investment decisions. When that change happens, some of your investments will perform worse. A handful might perform better. And, with some, it won’t make much of a difference at all.
Instead of losing sleep over inflation, keep your eye on the most important part of investing: ensuring that your portfolio is structured to get you closer to your financial and life goals, in a way that lets you sleep well at night. That’s the kind of strategy which will always hold you in good stead, no matter how negative the news about inflation happens to be.