Many investors, noting the effect on their wallets while shopping at the grocery store or filling up at the gas station, are worried about an increase in inflation — total CPI, which includes volatile items like food and energy is running at 3.4% and the “core” rate at 1.5%. But, you wouldn’t know it by looking at the bond market: 10-year Canada bonds are yielding 3.51% and are trading close to their 52-week highs. The difference between the yields on real-return bonds (1.55%) and long-term bonds (4.0%) suggests that the markets are guessing that inflation in the future will be a rather modest 2.5%. Nevertheless, here’s how various asset classes have behaved in an inflationary environment:
- Bonds: Estimating the effect of rising inflation on bonds is easy — it’s bad. And history bears this out. In the 1960s, inflation in Canada averaged 2.6% but spiked in the 1970s to 7.6%. Real returns on bonds fell an average of 1.6% during that decade. It is the direction of inflation that matters, not its absolute level. In the 1980s, inflation averaged 6.2% (lower than the previous decade) and the real return on bonds averaged 6.4%.
- Real-Return Bonds: Inflation-protection is the raison d’etre of real-return bonds as both the coupon and principal are adjusted for inflation. As already noted, befitting their low-risk nature, the current yield on these bonds is quite low.
- Real Estate: In Unconventional Success, David Swensen points out that real estate has a high correlation with inflation due to the ability of landlords to increase rents and increase in asset values to reflect higher replacement costs. However, this is only true when valuations are not extreme. Assuming that valuations are “normal” most of the time, REITs perform well as an inflation hedge.
- Gold: Any discussion of inflation will invariably turn to gold. There are two views on investing in gold. Some, like Benjamin Graham, opine that the US Government did investors a favour when it disallowed its citizens to own gold. Others, like William Bernstein, point out that a small allocation to precious metal equities and diligent rebalancing will help in periods where inflation is soaring.
- Stocks: Increasing inflation has a negative effect on stocks in the short run as future earnings are discounted at a higher rate and reflected in lower prices. But, in the longer term, at least in theory, businesses will find a way to pass along increasing costs to customers, which will find its way to the bottom line as an increase in earnings. In his commentary in The Intelligent Investor, Jason Zweig notes that out of 64 five-year periods since 1926, stocks have outpaced inflation 78% of the time. During the 1970s, the real return on Canadian equities was 2.4% (-0.7% in the US). Stocks do live up to their reputation of inflation hedges over the long-term but over the short term, all bets are off.
Bottomline: Rising inflation is bad for bonds but stocks, precious metals and real estate are reasonable but not perfect hedges. The only perfect inflation hedge is a real-return bond but their yields are very low.
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13 responses so far ↓
1 Phil S // Sep 2, 2008 at 12:47 am
Keep in mind that real return bonds (which I have in my portfolio) only track the “core” CPI, which is the CPI with food & energy stripped out. So, I think you would have to hold a portfolio of real return bonds & some selected stocks of companies whose products are the CAUSE of inflation, as you indicated, one big component of CPI being shelter, in the form of rent or the value of real estate.
The problem, of course, with the theory of picking stocks of businesses which are causing the inflation is that you are introducing management risk. Using this theory, Loblaws or Maple Leaf Foods stock, for example, should theoretically go up in the high inflation environment because they form the food component. But everybody knows that the Loblaws’ share price is being dragged down for years due to distribution issues, competition, poor promotion, bad public relations and this kid at CEO who was handed the reins of the company not based upon merit, but rather because of his lineage. Of course, Maple Leaf has had the snot pounded out of its shares due to the recent outbreak. REITs like Riocan may be less dangerous in terms of management risk, but I think real estate IS part of the “core” CPI.
My point is that if you can stomach the volatility due to “management risk”, then by all means, you can go ahead and use that theory.
I haven’t checked myself personally, but I don’t think there’s a nice linear relationshop between gold prices and inflation, either. It seems to me that gold prices are much more volatile than the CPI and they don’t always head in the same direction. Can you make money on gold? Certainly! Many people have - including people I know personally. Is it correlated to inflation? I don’t think so, and I don’t think anybody can convince me that it is…
Although I like to purchase gold baubles, I don’t like to count on gold as an investment vehicle that is an inflation hedge. After all, gold doesn’t pay any interest nor any dividends. Also, I purchase gold baubles as luxury items - I wouldn’t if I were in financial trouble and I wouldn’t expect any other consumers out there to do that either if consumer confidence turns (my point is that gold jewelry as “bling bling” has elastic demand).
2 Investing in an Inflationary World : thegameoflove // Sep 2, 2008 at 12:49 am
[...] Original post by Canadian Capitalist [...]
3 CanadianInvestor // Sep 2, 2008 at 4:25 am
Another asset class that can do well in inflationary times and whose components include the oil and basic foodstuffs that are the current inflation culprits is commodities e.g. funds like DJP, GSG, GSP, DBC. These funds have done well in the past year.
4 Doug // Sep 2, 2008 at 7:39 am
“Infrastructure” is another investment that is more resistant to inflation. I suggest that you go to the websites of the CPP and the Ontario Teachers Pension Plan. Both are invested in infrastructure. Is their an ETF for this?
5 NN // Sep 2, 2008 at 10:13 am
Phil S - I believe there are a couple of studies that show how gold is correlated with inflation - e.g. for the past 3000 (!!!)years or so 1 ounce of gold would have bought one suite of superior quality (exclude Armani or any of the other overpriced brands). You are right on two counts though: it is more volatile (usually driven by the FEAR of increasing inflation), and a long term investor will not beat inflation, i.e. the real return is low, or nothing. People who make money in the gold market essentially rely on market timing, and the ‘average’ investor should probably not attempt that.
CC - no mention of Cash? I thought cash was the ultimate inflation hedge :).
I wonder if it is wise (for the ‘average’ investor) to consider macro economic trends such as inflation in making short or medium term asset allocation decisions?
As mentioned before, I am a young investor with no qualms about absorbing short term volatility, as long as the long term returns beat inflation - Equities and REIT/Property before anything else for me.
6 Canadian Capitalist // Sep 2, 2008 at 11:08 am
Doug: There is a new Claymore Infrastructure ETF (CIF). I’m working on a post on this topic and would be happy to send you reading materials.
CI: Some people mention commodities as a separate asset class but I have my doubts whether they are suitable long-term holdings.
Phil: I agree with you that gold doesn’t have a perfect correlation with inflation. I avoid “investing” in physical gold and have no allocation to gold equities either.
7 Canadian Capitalist // Sep 2, 2008 at 11:13 am
NN: The real returns on cash seem to be similar to bonds i.e. negative (but not as much as bonds) in periods of rising inflation and positive (again not as much as bonds) when it is falling. I agree with you that asset allocation policy should not depend on short-term macroeconomic expectations. After all, not too long back investors were worried about deflation, not run-away inflation. And bond markets seem to be expecting inflation to be muted.
8 Jon202 // Sep 2, 2008 at 12:59 pm
Kevin O’Leary from BNN always says to look at the U.S. long bond (30 yr. tbill) for inflation rates.
http://www.bloomberg.com/markets/rates/
I’m not saying he’s right, just adding some kerosene to the fire.
9 Fred // Sep 2, 2008 at 8:14 pm
Jon202:
Ken Fisher says much the same. In “The Only Three Questions That Count” on page 232, Ken suggests that the reader refer to global long-term bond rates to get a sense of global inflation.
10 Canadian Capitalist // Sep 2, 2008 at 8:37 pm
Jon, Fred: US bond yields suggest modest inflation expectations as well. The yield on 30-year treasuries is 4.37% and 30 year TIPS is 2.10%, suggesting inflation expectations of around 2.5%.
11 berchta dale // Sep 4, 2008 at 8:38 am
Before you invest in any type of bond, it is important to know how bonds work. Bonds can be complicated to understand at first since there are many types of bonds and therefore many rules. It is also more important to understand how bonds work when you invest in bonds because people usually invest in bonds for the interest payments as well as redemption value which are something in the future. While when a stock goes down in value you know you are losing money, when a bond goes down in value, you may not be losing money but if you understand perfectly how your bonds work.
12 Weekly Roundup: Third Baby and Last Retaining Wall Edition at Clever Dude Personal Finance & Money // Sep 14, 2008 at 3:51 pm
[...] - Canadian Capitalist advises on investing in an inflationary world [...]
13 Thicken My Wallet » Blog Archive » Implications of the bail-out on you and me // Sep 29, 2008 at 5:02 am
[...] Here comes inflation. Inflation is upward movement of the price of goods and service. In other words, a buck doesn’t get you what it use to. Inflation is caused by a wide-variety of factors but one cause is the increased circulation of money into the monetary system. Guess how the American government is going to fund the bail-out? Yep, putting more money into circulation. Canadian Capitalist has some tips (no pun intended) on investing in an inflationary world. [...]
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