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Deep Dive – What Assets Should You Invest In To Protect Your Portfolio Against Inflation?

Deep Dive – What Assets Should You Invest In To Protect Your Portfolio Against Inflation?

This post was first posted on the Patreon page already on 13 June 2020.

The Covid-19 coronavirus has rocked the boat during the first half of 2020 and made a huge dent on financial markets and on the growth of the economy. We are still only in the beginning phases of the turmoil, and it is only in the future that we will truly get a picture of all consequences and how the virus will affect the world economy and global trade. 

In this article, we will be taking a closer look at what actions central banks and governments have taken to stimulate the economy; how such stimulus may affect inflation; what asset you can invest in to be protected against inflation; and how such assets fit in the All Seasons Portfolio Strategy.

Even though many things are uncertain, a couple of things we do already know for sure though, and that is that many are likely to lose their jobs and that many companies are likely to have no choice than to file for bankruptcy. This would have devastating consequences for the economy in many countries, but even more so for the people affected by the growing unemployment rates.In a response to the potential crisis and alleviate the harmful impacts, governments and central banks have acted quickly and they have acted strongly. 

Governments around the world have opened the taps and are now aiding companies and employees by grants and support. At the same time, central banks are flooding the money markets with liquidity. Mainly, the Fed and ECB have both made commitments counted in trillions of dollars and euros respectively. 

To date (by mid-June), more than 15 trillion dollars have been committed globally, where of Fed has committed 6 trillion dollars, meaning that the central banks’ balance sheets have swelled to record levels. In comparison, the total GDP in the EU in 2018 was 15.9 trillion dollars.

The stimulus commitments are therefore nothing less than staggering.However, as both the Fed and the ECB have now echoed Mario Draghi’s famous word that they will “do whatever it takes” to rescue the economy, further trillions can be expected if either or both scenarios 1) the coronavirus outbreak will last longer than expected or 2) the negative impact on the economy is more severe than expected, would become reality.

Short term effects of central bank stimulus

But how will the coronavirus outbreak and the printing of money impact inflation?In the short term, it is likely that inflation will stay low. This is largely due to the quick downturn in consumer demand. When people have been in lockdown, restaurants been closed and the tourism sector more or less completely shut down. The possibilities to consume have thus been very limited.

Further fueled by a worry for whether one will lose one’s job, there are few arguments for people to go on a spending spree.This has had second level impact on other industries such as logistics and manufacturing. If fewer are buying the newest iPhone, fewer iPhones need to be produced and shipped across the globe.

This has put pressure on oil and commodity prices as well, as the ships with ability to carry tens of thousands of containers have been left idling outside the harbours waiting for deployment.Therefore, it is likely that in the nearest future, inflation should go down, at least for as long as the virus outbreak is active with the consequent lockdowns.

Long term effects of central bank stimulus

Looking a bit further ahead, the outbreak will culminate one day and society will begin to properly open up again after the long period of lockdowns when many companies have been shut. Then, investments will begin again, companies that had been shut reopen, and people who have lost their jobs will find new employment. One day, no matter how distant it may seem today, things will revert back to a state that can be recognized as “normal”.

However, when consuming, spending and investing will start up again, this will be riding on the wave of great stimulus from central banks and governments. Vast amounts of new money will have been pumped into the monetary system to both keep the economy afloat during the crisis, and to kick start it again when the crisis ends.

It is important to note though, that expanded central bank balance sheets of USD 15 trillion does not mean that there is 15 trillion new cash already out in the system. These are still mainly commitments, available for use when needed. Some of it is of course printed and in use, as governments have paid out grants and banks have increased lending these past months. The important factor is for how long the health crisis will last, and thus, how much of the committed USD 15 trillion will be used, and whether this amount will increase further.

Money supply is therefore increasing for each day that the outbreak lasts. Paired with the increased rate of household spending from the low levels during the outbreak, the greater money supply may trigger higher inflation. We may be witnessing a sudden shock to the supply chains of consumer goods and increased demand, which in term will be increasing scarcity of certain goods and driving up prices.

Looking at the development of money supply, the increases the past months during the spring of 2020 have been historically high.For example, by February 2020, the M2 Money Supply in the United States (M2 includes not only cash, but also savings deposits, retail money funds and small time deposits) had increased year-on-year by 6.3 percent (according to Federal Reserve Bank of St. Louis). This increase level had, however, not been able to curb the otherwise low inflation rate before the covid-19 outbreak.

However, during the next six weeks from end of February until 6 April, another 7.7 percent was added, which equals to an annual compounded rate of staggering 90.4 percent.This printing of money has continued ever since, and the total M2 had increased from about 15 trillion dollars in the United States by end February 2020 to more than 18 trillion dollars by end of May 2020 – an increase of 25% in just three months – according to Federal Reserve Bank of St. Louis. This is visualised by the below graph that shows the dramatic hockey stick like increase in M2. 

Depending on for how much longer the hockey stick development for the M2 volume will continue, the more likely it is that higher inflation rates is to come. At least, this would be the case, would the velocity of money increases, meaning the ratio between GDP and M2. This is a measure for how quickly each unit of money in the system changes hands. During the lockdowns, the velocity has decreased when consumption has gone down, but when spending begins again after the crisis, the velocity of money is likely to increase again from the very low levels in the initial phases of the crisis. 

Now, in the first half of 2020, money (M2) has increased, but consumption has decreased. Let, when consumption will again start, it is likely that the velocity will increase again while the increase of M2 will culminate as central banks decrease their stimulus efforts. 

Federal Reserve Bank of St. Louis, Velocity of M2 Money Stock [M2V], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/M2V, May 25, 2020.

Thus, we will witness increased consumption and levels of transaction, after the economic system has been filled with fresh trillions of dollars to spend.

Prepare your portfolio for increased inflation

It is not 100% certain that we will see high levels of inflation, but the chance has risen according to Martin Wolf at Financial Times. Some predict, that by 2022, the United States inflation will reach toward two-digit numbers, according to Martin Hutchinson.

But the thing is, even though we do not know for certain what will happen, we can prepare for the eventuality.If inflation would remain low, that will benefit stocks. You will presumably be riding that wave if the economic growth would pick up, as most investors are heavily exposed to stocks. However, if inflation would increase, that could have a negative impact on stocks. Thus, if you are one of the investors whose portfolio is heavily or exclusively exposed to equity-linked investments, your wealth may be at risk.

What can you do to prepare for inflation?

To avoid great drawdowns and losses, it is wise to take protective measures. You can hedge against the possibility of higher than expected inflation by including other kinds of assets in your portfolio in addition to your stocks.Here, we will go through three types of assets that protect you against inflation.

1. Real Estate

Real assets is one of the best protectors against inflation. If price levels in general go up in the economy, so will the prices of real assets.Owning real estate is therefore a great hedge in an environment where we could face higher than expected inflation. This means that if you own your home, you are already somewhat protected. But if you need to sell your home to liquefy your inflation hedge, it is a transaction that will take time to complete.

It may therefore be wise to also get exposure to real estate in your investment portfolio, for example by investing in Real Estate Investment Trusts – or “REITs” for short. However, as real estate is an equity-linked investment, the value will not perform well in a market environment of lower than expected economic growth.

The reason for this is that the value of the asset is contingent on the purchasing power in general. The values of properties are thus likely to fall in a recession. But in an inflationary environment, real estate provides a great hedge, but only if leverage is low. This is because when inflation hits, the central banks are going to increase rates to counter inflation, which will increase interest costs on the loans you have against the property.

If you would like to start direct investing in real estate but can’t afford to purchase a whole property, you could look for crowdfunding solutions, such as BitOfProperty or Brickstarter, where you can get started for as little as EUR 50.

In conclusion, while real estate offers protection against inflation, you will not be protected against stagflation, when inflation is combined with negative economic growth. If you invest in real estate, you will need to find another hedge against low growth.

2. Inflation-Linked Bonds / TIPS

A classical hedge against inflation is inflation-linked bonds, or “TIPS “as they are known as when issued by the United States government. Inflation-linked bonds are securities, that protect the purchasing power of the bond investment. This is done by adjusting the principal amount of the bond by indexing it against inflation, for example Consumer Price Index (depending on issuing government). This ensures that both the real coupon and the real face value will be maintained for the life of the bonds.

In essence, the face value is tied to the development CPI and is adjusted annually. The coupon is fixed, but the interest paid will increase over time as the bond’s face value increases. For example, let us imagine a bond with face value of 100 during year 1 and a coupon of 3%. If inflation would be 2% at the indexing date, the face value of the bond would be increased to 102, and in turn, and the coupon is calculated on that principal amount. So instead of receiving $3 as in year 1, the investor would in year 2 be paid $3.06.This means that by including inflation-linked bonds in your portfolio, you will have a protection against rising inflation, as the purchasing power of your investment will not be weakened when the inflation rate increases.

But about times of deflation, will your face value also decrease? Well, that would have been the logical effect of an indexation against CPI, but, most inflation-linked bonds have a zero floor, meaning that if inflation is negative, the annual adjustment will never be less than zero. Of the developed countries, it is only inflation-linked bonds issued by the UK government that are lacking such zero floor.

However, this does not mean that you are protected against deflation. You would be losing out by the alternative cost of the investment. Because you as investor are not exposed to inflation, the inflation risk premium is excluded when the bond’s interest rate is priced. A simplified example is that the “ordinary” bond equivalent of the 3% inflation-linked bond we presented earlier, would have a yield of for example 5%, as the inflation premium would be included in the price at the time when the bond is first issued. This means that in a deflationary environment, the value of an ordinary bond is a much better investment than the inflation-linked bond (5% vs. 3%), as the bond holder receives his inflation premium regardless if inflation actually turned out to be negative. 

But what about stagflation? Bonds in general –  both regular ones and the inflation-linked ones – perform well in times of lower than expected economic growth. This means that inflation-linked bonds is a great hedge for both times of high inflation and times of low economic growth. Thus, if you fear that stagflation might be on our radar ahead, inflation-linked bonds are a great tool to hedge against such environment.

3. Gold

Our third asset we will be looking at in this expose is perhaps the most widely recognized inflation hedge, namely gold. Gold has for millennia been considered to be the ultimate storage of value.

Until the end of the Bretton Woods monetary system in 1971, many currencies were backed by physical gold. When debt levels had expanded too much and too rapidly, governments saw the only solution to be to decrease the debt amount by inflating the money in circulation. This gave central banks an ability to freely create money and credit, which in turn led to high inflation and low interest rates over time. 

Gold is a scarce resource and the total amount of gold available in the world increases at a very slow rate. Gold is also a noble metal that will not decay over time. This means that gold is not likely to entirely lose its value, for as long as the investor collective finds gold to be a good way to store value. 

Gold is also considered to be a safe-haven in distressed times when investors have a risk off attitude to investing. Thus, gold will not only protect you against inflation, but only stagflation, as the gold price is pushed up by increased demand when investors leave equity-linked assets to instead park their money in gold.

The main argument against including gold in a portfolio is that it does not produce value and you get no additional cash flow from it (rather the opposite, if you have to pay for storing your gold in a safe manner).

However, as trillions of dollars are currently invested all over the world in bonds with negative or near-negative yield, the difference in value production between gold and bonds has become almost negligible. But while bonds does not offer protection against inflation, gold does. 

To ensure your purchasing power will remain through times of higher inflation, you should consider including gold as part of your investment portfolio.

For further reading on the changing value of money, and how fiat currencies devalue against gold, check out the chapter on this in The New World Order as written by Ray Dalio, and which is released chapter by chapter on LinkedIn: https://www.linkedin.com/pulse/changing-value-money-ray-dalio/

Inflation-protection in the All Seasons Portfolio

If you were to rebalance your exposure in your portfolio so that you are protected against rising inflation, how should you do it? If you today are invested solely in stocks, or have a classical 70/30 portfolio of stocks and bonds, you are very vulnerable if inflation was to rise. 

Given that the central banks’ balance sheets are growing and more fiat money is flooding the monetary systems, higher inflation actually is actually beginning to become one likely scenario. 

Presumably, you will already have exposure to the market if economic growth would pick up speed again after the coronavirus outbreak. Your stocks will give you this exposure already. We will therefore focus less on assets that offer both inflation protection and that do well in good economic environments. Such assets are real estate and commodities. Thus, if you were to include for example REITs in your portfolio, you should at least partially treat them as you would treat stocks, as REITs and stocks react differently to inflation, but correlate when considering economic growth.

Instead, let us focus more on assets that protect you against high inflation and low economic growth, or stagflation. As we described earlier, you would then need to include gold and inflation-linked bonds in your investment portfolio.

These are both key components of the All Seasons Portfolio investment strategy, and are included in the strategy exactly for the purpose of inflation protection.In the traditional All Seasons Portfolio, your gold part should amount to 7.5% of your holdings, and inflation-linked bonds should constitute 15%.

For examples of ETFs to pick, see the ETF Inspiration Page.

By diversifying between asset classes, you will decrease volatility and, in turn, your risk.  

In conclusion

The coronavirus outbreak has been an unprecedented collapse in economic output, and has had devastating effects on the economy and for many workers. To counter the worst effects, governments and central banks have launched record breaking stimulus packages and “central bank bazookas”, hoping to hold the economy afloat through the initial phases of the health crisis.

The stimulus packages will mean that more money enters into the financial system and increase debt levels. Exactly how this will impact inflation remains to be seen, but it is very unlikely that nothing will happen. At the very least, prices of assets such as stocks and property will be inflated, but there is also risk for a monetary inflation.

In the very short term, deflation is most likely. Consumption is kept at extremely low levels as consumer behaviour is restricted. Consumers are not able to buy travel, goods or experiences in the same way as before, while in isolation or with social distancing requirements.

When the economy kicks off again though, with the increased amount of money (M2) available, there is an increased possibility for inflation. This possibility increases for each day that the health crisis lasts and that stimulus packages are used and added. 

The wise and sound investor should be prepared for any eventuality. We have therefore identified three asset types that will hedge your portfolio against inflation: real estate, inflation-linked bonds, and gold. Of these, the two latter ones will also protect you against stagflation, i.e. an environment of both inflation and negative economic growth.

Both inflation-linked bonds and gold are included in the standard All Seasons Portfolio strategy. If you want to lower the volatility of your portfolio and protect your wealth, you should consider diversifying between assets, and include inflation protection to your portfolio. If you follow the All Seasons Portfolio strategy, your inflation protection in your portfolio will consist of 7.5% gold, 15% inflation-linked bonds and 7.5% commodities.

No one knows for sure what will happen in the near term, and the current health crisis has pushed the level of uncertainty through the roof. But even if you cannot predict what will happen, you can prepare for the eventuality to avoid big losses and drawdowns. Take this opportunity to review how you have positioned your portfolio and act before inflation hits. Otherwise it will be too late, and the protective assets have already surged in price. 

Have you prepared your portfolio, or what are your thoughts on whether we will see inflation in the near future?  


Book tip: Naked Money by Charles Wheelan

Charles Wheelan is a formed correspondent of The Economist, and a professor at the University of Chicago. In Naked Money, Wheelan explains monetary policy in an entertaining and whimsical, yet educating way.

Naked Money is one of the most popular books on Amazon on the topic of inflation and fiat currency. Wheelan describes monetary policy and the pros and cons of the Feds tool box.

Consider the $20 bill. It has no more value, as a simple slip of paper, than Monopoly money. Yet even children recognize that tearing one into small pieces is an act of inconceivable stupidity. What makes a $20 bill actually worth twenty dollars? In the third volume of his best-selling Naked series, Charles Wheelan uses this seemingly simple question to open the door to the surprisingly colorful world of money and banking.

The search for an answer triggers countless other questions along the way: Why does paper money even exist? And why do some nations, like Zimbabwe in the 1990s, print so much of it that it becomes more valuable as toilet paper than as currency? How do central banks use the power of money creation to stop financial crises? Why does most of Europe share a common currency, and why has that arrangement caused so much trouble? And will payment apps, bitcoin, or other new technologies render all of this moot?

In Naked Money, Wheelan tackles all of the above and more, showing us how our banking and monetary systems should work in ideal situations and revealing the havoc and suffering caused in real situations by inflation, deflation, illiquidity, and other monetary effects. Throughout, Wheelan’s uniquely bright-eyed, whimsical style brings levity and clarity to a subject often devoid of both. With illuminating stories from Argentina, Zimbabwe, North Korea, America, China, and elsewhere around the globe, Wheelan demystifies the curious world behind the paper in our wallets and the digits in our bank accounts.

Buy it on Amazon.com

This Post Has 9 Comments

  1. Thanks for the info shared in this article. You did a great job. I agree pretty much with everything. Personally, for reasons that you said in the article and for some researches I have done about a balanced portfolio (see Alex Shaidi book you mentioned last time) I have reduced my long term bond allocation to 30% and increased gold and TIPS allocations. I also added a small % of btc for some equity. I like the shape my portfolio has right now. Let’s see how it will perform.

    1. Many thanks Carlo for the kind comment.
      In this environment, it seems wise to balance for increased inflation – I will be reallocating more into TIPS as well this coming week, and I have already been overweight in gold for quite some time, which has worked out well the past quarter.
      It is a really good book (Balanced Asset Allocation) by Alex Shahidi, and it gives a solid reasoning behind the biases of each asset class. If the economic environment was uncertain when he wrote the book in December 2013, it must be twice as uncertain today with everything going on. Interesting times lie ahead, and it is good to hear you have achieved good diversification.
      I always appreciate hearing from you, and considering what we may be going through in the markets in the near future, I look forward to hearing from you again and how your portfolio performs.
      -Nicholas

    2. And as for BTC, it may be a good hedge as well, considering we have no idea what is to come. I believe that if fiat currencies would have to be abandoned one day following the current chain of events, we may see a stablecoin promoted by central banks as a viable alternative. When that alternative is brought to the table, I am sure BTC and major cryptocurrencies will surge.

  2. Hi Nicolas,
    natural resources companies and gold mining companies are also doing very well against inflation.
    The possession of natural resources companies allows to avoid the problems of contango and backwardation of ETC in commodities.
    Also, I prefer shares of gold mining companies instead of ETC.
    ETC do not have the structure of UCTIS funds, but are bonds.
    Are you sure that in case of need you will have your gold bars?
    Finally, natural resources companies and gold mining companies pay a dividend, so for the benefit of fighting inflation, keep the risk premium.
    Here are two ETFs in Europe:
    – Vectors Natural Resources UCITS ETF (IE00BDFBTK17)
    – ComStage NYSE Arca Gold BUGS UCITS ETF (LU0488317701)
    Best wishes.

    1. Hi Paolo,
      Thanks for the great input. I agree that mining companies show lower correlation with the stock market, and offer some protection against inflation and avoiding contango. That is a very attractive selling point for mining companies, as there are no real effective commodities ETFs in Europe that deal with efficient rolling of futures contracts. In my opinion however, certain issues remain with mining companies:
      – Mining companies are still companies, with exposure to the financial markets. They have credit lines with banks and are exposed to the general risk appetite on the stock market.
      – miners often enter into forward contracts as well to lock in a sell price to better plan their income stream. This means that they could hedge themselves out of profits if prices turn up. This means that there could be considerable lag in the increase in the stock price of the mining company after the commodity price increase, causing added volatility in the portfolio as stocks would have dragged it down, while commodity stocks have not managed to offset that dip.

      Unfortunately, commodities is still a small category of asset classes, mainly due to a negative effect of recency bias, why there is very few good UCITS ETFs.

      Have you been able to compare the natural resources company ETFs with a futures ETF through times of high inflation? Not sure if there is data available from e.g. the 1970s but would be interesting to see if this ETF would follow commodity prices upwards or stock prices downwards – or something in between – when inflation strikes.

      As you say, while a gold ETC gives you the right to trade in your units to a physical gold with the custodian, in a time of extreme crisis, that might not be possible to effectuate quickly (doomsday scenario). The trade-in right is a legal relationship, so as long as there is a functioning legal system, you retain the right to the gold. But in a scenario of extreme distress, perhaps stock will not give much comfort either?

      How is your allocation to mining companies? Do you maintain a 7.5% exposure as with the All Seasons Portfolio, or have you made any adjustments taking into account the company risk?

      Thank you,
      Nicholas

  3. Hi Nicholas
    thanks for your answer.
    Obviously I do not argue that gold mining companies and commodity producers are better, only that there are other ways to cover inflation.
    Using Portfoliovisualizer you can see how there is a strong correlation between GLD (in gold bars) and GDX (in gold miners shares), the value in the period Jan 2007 – Jun 2020 is equal to 0.82.
    I do recognize, however, that GLD has a better Sharpe Index (0.45) than GDX (0.17).
    However GDX is an ETF that invests in shares of gold mining companies, including those that enter into contracts to hedge the gold price.
    The Comstage Arca gold bugs is an ETF which invests only in companies that do not cover the price of gold beyond 18 months. Therefore, track the price of gold more faithfully. Unfortunately it is not listed in America, so you cannot use Portfoliovisualizer.
    Instead, I think the counterparty risk of ETCs should be carefully valued by investors. This article explains very well the risks you run when purchasing an ETC:https: //www.forbes.com/sites/oliviergarret/2017/03/09/3-reasons-why-investors-should-avoid-gold-etfs/#7f6d53804dd8
    So I prefer ETFs in gold mining companies.
    As for commodities, the Portfoliovisualizer data in the period Jan 2009 – Jun 2020 indicate a correlation between DBC (futures commodity) and HAP (commodity producer) equal to 0.84, with, a better Sharpe index: DBC -0.20; HAP 0.28.
    As for my portfolio, I am a follower of Alex Shahidi.
    My portfolio is very similar to the RPAR ETF:
    – low growth / low inflation: 30% “Xtrackers II Eurozone Government Bond 25+”;
    – low growth / high inflation: 30% “UBS – Bloomberg Barclays Euro Inflation Linked 10+”
    – high growth / low inflation: 20% “Spdr Msci Acwi Imi”
    – high growth / high inflation: 10% “Vaneck Natural Resources” and 10% “ComStage NYSE Arca Gold BUGS”
    Best wishes.
    Paolo

    1. Hi Paolo,
      Sorry, I may have jumped to conclusion when responding last time. I misunderstood it as if you meant something superior instead of an alternative.
      I am a big fan of Shahidi as well, and correct me if I am wrong, but I believe that he is also involved in the RPAR ETF (at least he is co-founder of ARIS that manages the RPAR ETF).
      It is a shame that there are so few good commodities ETFs in Europe. If there could be one similar to the USCI in the United States that is a bit “smarter” when it comes to selecting the futures contracts for each rebalancing (it selects 14 out of 23, with the best buy signals).
      However, I have found the “L&G Longer Dated All Commodities UCITS ETF” (IE00B4WPHX27), which is a bit better than a ‘regular’ commodities futures ETF, as the futures contracts it invests in have maturities of 3 months instead of 1 month, which slightly decreases rolling risk. It is still down 10% YTD, but that is at least a bit better than -15% as my ETF that tracks the Bloomberg Commodity index. (The L&G ETF also tracks Bloomberg Commodity index, but with different duration).
      I’ll read your linked Forbes article next about the ETCs, and get back on this at a later time.
      As for your portfolio, it looks like you have found very decent ETFs tracking the European market. I understand you are taking a “home market” approach, which is sensible 🙂
      In the light that Comstage Arca Gold Bugs only invest in companies that do not cover the gold price, it sounds like a better alternative than I would have first thought. But do you think gold belongs in the high growth / high inflation bucket? My immediate interpretation would be that gold is more similar with TIPS (low growth / high inflation), considering it is a safe haven during bad times on the stock market, and is not a commodity in the same sense as copper, oil or grains (it is not input in manufacturing or any products in the consumer price index)? Or do you include it here because you are investing in gold mining companies, i.e. stocks, that perform well in a high growth environment? I am aware I may have missed something here, but happy to hear your thoughts.
      All the best,
      Nicholas

  4. Hi Nicholas,
    it is always a pleasure to exchange opinions with you.
    I fully agree with you that gold is a hedge in times of low growth and / or high inflation.
    In my draft I simply put together gold and raw materials because they have the same weight in the portfolio.
    Again thanks for the blog.
    Best wishes.

    1. Hi Paolo,
      The feeling is mutual, I always look forward to hearing from you.
      I understand, and note that gold is also often already included to some extent in any commodity ETF with futures contracts as the underlying asset.
      Talk to you soon,
      Nicholas

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