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GlossaryA Diabolical Challenge
October 24, 2021Money is both a constant in human life and constantly unstable, like the ocean. Sometimes money lurches from one market to another, like a stock market crash. Sometimes prices begin to rise, like now. Eggs cost 12% more than a year ago. An egg is an egg, you just pay more for it. If your wealth is fixed and eggs cost more, effectively you are now poorer.
Inflation is tricky for investors. Some of the assets most commonly owned, like stocks, generally don’t do well when inflation becomes a problem (though they have done well this year). Once people become alert to inflation, the assets that can help protect are already expensive. And, if in response, the central bank sharply reduces the amount of money it is printing all assets fall.
To deal with this, professional investors resort to other techniques, like futures and shorting that are not a good idea for the untrained. Shorting in brief: Say a box of eggs costs $10. I can short it by saying, “I’ll pay you $10 for your eggs…in a month.” I borrow your eggs and sell them for $10 that day. When the price of eggs falls to, say, $5 in a month, I buy the eggs and give you yours back. I sold for $10 and bought for $5, making $5. Like I said, shorting is complicated.
The Problem
Economists can not reliably predict when inflation is going to shift higher or lower because inflation has too many moving parts. Inflation is the average price of a pile of stuff, from semi-conductors to cement. While keeping track of all the moving parts is impossible, as a hack I reduce inflation to just three pieces: labor, raw materials and housing.
For everything you buy, someone needs to make it (labor) and transport it (raw materials), and all involved need a roof over their head. That’s inflation. The below chart shows actual CPI, as reported by the government, and then an estimate (thanks Rose!) that is 66% labor, 17% commodities and 17% housing. It tracks pretty well and you can see the prices jump recently.
In the US over the next 10 years, inflation is expected to be about 2.5%. This isn’t an opinion. This number is extracted from the bond market by looking at the difference between what’s called a nominal bond and an inflation-linked bond. This measure of expectations is objective, like your weight on a scale.
Inflation right now is around 5%. This means the market believes inflation will fall from here (from 5% to 2.5%). I suspect that is right. Think labor, commodities and shelter. Tens of millions of people are seeing their jobs disrupted, which has created supply/demand imbalances as has an exodus from cities to suburbs. That said, I could be wrong, so I need to have a plan.
Least-Worst Solutions
There are three assets that might help an investor navigate inflation: real estate, commodities and inflation-linked bonds. Real estate and commodities are almost intuitive. If you think food prices were going to spike further, it makes some sense to fill your home or apartment with food today and eat it tomorrow. Wherever inflation settles the real estate and commodities will sell at that price.
Inflation-linked bonds are less familiar, technical and a topic a reader asked about. An IL-bonds pay you real (inflation-adjusted) interest. That means if inflation rises further from here, you get more money, which would help. It also means an inflation linked bond has two moving parts, a real yield and inflation compensation. A regular ten-year nominal bond yields 1.7% thus can be divided into a roughly 2.5% expected inflation rate and a negative real yield. Why would you buy a bond with a negative real yield?
Because yields on cash are even lower. Cash is zero and inflation is 5%, meaning real cash yields are -5%. If there is a fundamental force in markets, like nuclear energy, it is these real yields. When cash is a terrible investment it forces money out into the economy and markets. These yields impact every asset you can buy.
IL-bond real yields can rise (hurting an investor) in one of two ways—either inflation falls (and real yields thus rise) or the Fed raises rates. The long-term chart below shows the relationship of interest rates to a popular nominal bond ETF. When the Fed raises rates, it is not pretty. An inflation linked bond will look even worse.
From here, inflation likely falls or I am wrong and it rises and the Fed acts. If inflation rises further and the Fed does nothing, inflation linked bonds are a good deal. That could happen, but investing is about making good risk reward decisions. Given how low short-term interest rates are right now, the cost of selling short-term bonds is low. These are the interest rates the Fed would raise. While this is NOT investment advice and you can and will lose money investing, for transparency my inflation hedge is a roughly 30% short on short-term interest rates, 10% long commodities and 8% long real estate. I don’t hold any inflation linked bonds.