In response to the credit crisis, central banks authorities and governments around the world have taken unprecedented action in providing massive fiscal and monetary stimulus. Warren Buffett, in a recent interview with CNBC, said that such actions have the potential to be “very inflationary”. In the same interview Buffett had some suggestions for investors for preparing for any spike in inflation in the future:

But we are certainly doing things that could lead to a lot of inflation, and the best asset during inflation is your own earning power. Anything you do to improve your own talents and make yourself more valuable will get paid off in terms of appropriate real purchasing power. If you do something well, whether you’re a major league baseball player, you know, whatever it may be, if you’re a good assistant, whatever it may be, that’s the best asset. The–in my view, the second best asset is a good business. And you might own one yourself, but you might own it through equities.

He expanded on why he thinks stocks will be the second best asset class:

You know, if the dollar becomes way–worth way less, we will sell See’s Candy for more money. I mean, it won’t be more real dollars, but we–if somebody’s willing to give up 15 minutes of their labor or half to buy a pound of this or to buy six cans of this, they’ll do the same thing and it won’t make any difference whether shark’s teeth are being used for money, basically.

But, as Jeremy Siegel notes in Stocks for the Long Run, “neither stocks neither stocks nor bonds nor bills are good short-term hedges against inflation”. Over the long-term, though, “the real returns on stocks are virtually unaffected by the inflation rate”. The reason, as Buffett pointed out in his interview is that stocks are claims on the earnings of real assets “whose value is intrinsically related to labor and capital”.

There is evidence that other asset classes such as gold (over the long-term) and real estate provide some measure of inflation protection. The Canada Pension Plan also lists infrastructure among its inflation-sensitive holdings.

There will be one clear loser if inflation does spike in the future: traditional Government bonds. Retirees depending on portfolio income for maintaining their standard of living may want to consider keeping a large portion of their bond portfolio in real return bonds, which provide a perfect hedge against inflation. Interestingly, while long-term Canada bonds are yielding just over 3.5%, real return bonds are currently yielding a real return of 1.9%.

This article has 21 comments

  1. Pingback: Investing in a period of high inflation

  2. I also believe that we are headed for a very high inflationary period ones we get through this recession. It is often noted that real estate is a good hedge against inflation, for smaller investors who can not purchase real estate do you think REIT’s will be a similar hedge?

  3. Philip in North York

    “But, as Jeremy Siegel notes in Stocks for the Long Run, ‘neither stocks nor bonds nor bills are good short-term hedges against inflation’.”

    Can I suggest canned food or any long-shelf-life food for short-term hedges against inflation? I know it’s silly to call food as an investment vehicle unless selling it to someone in later time. However, I can protect my grocery bill from inflation in certain degree.

  4. Leading Edge Boomer

    Ray–buying what you need , and some of what you want, for use now or in the future, whenever you can get them on sale or at a depressed price is a good strategy at any time.

    Buffet is not the only one who has warned that this recession is likely to be followed by inflation, particularly this time around when governments are injecting cash into the economies of the world.

    Reits may be a decent hedge, but one does not want to put all of ones eggs in one asset class basket. Reits are also popular among those who want some income from their investments now. Retirees are usually bullish on them for this reason.

    If inflation eventually returns in a big way will not the world price of oil go up with it? If so will oil stocks not be a good hedge? This segues nicely into my next question.

    What do posters think of the proposed merger of Petro-Can with Suncor which was announced this morning?

  5. Leading Edge Boomer

    Oops–that should have said PHIl, not Ray

  6. The world seems to be split into 2 camps on whether inflation will be back anytime soon. I guess that’s no different than any other issue though.

    Of interest to many people today is mortgage rates, and how they will fair in an inflationary vs. non-inflationary environment. I’ve recently bucked the historical wisdom of taking a variable rate mortgage, and locked in 5-years. The spread between fixed and variable is just so narrow right now. Some commentators are arguing that this is still a time to be variable, and when there comes a whiff that rates are going up, to lock in then. The counterargument to that is that by the time the average Joe realizes it’s time to lock in, the banks will have raised the fixed rate higher than he could have gotten today. This becomes pay less today, pay more tomorrow. CC, could be a timely idea for a post, if you have the interest (no pun intended) – I’ve not seen this topic covered well recently.

  7. The interest rate on real return bonds is calculated based upon “core” CPI which measures inflation, but both food and energy are stripped out. On a practical basis, this doesn’t make any sense as we buy food and energy on a daily basis whereas we only purchase automobiles and plasma TVs when our existing assets fail.

    I don’t know that I would invest solely on the basis of inflation – but it would go to reason that a good hedge on inflation is to invest in the businesses that sell the commodity that is responsible for causing the inflation… Agribusiness, rental real estate, energy providers are some of the biggest influences on the measured CPI inflation rate.

    Unfortunately, you also have to factor in business risk. Are those companies being run by morons? How much debt do they have and do they have to go into the current bad credit market to raise cash? So, that’s why I wouldn’t advise anybody to invest in something based solely on inflation… I think even Warren Buffett made a comment about bonds that went something like “it’s better to buy a bond and break even on inflation than to buy an equity that drops by 90% of its value”…

  8. The investment simple portfolio demonstrated here with the TD e-trade purchases, does that comprise of the Real Return Bonds from the Government of Canada? Would a change to the investment techniques mentioned shelter from inflation?

  9. Once again Buffett is following his own agenda of “do as I say, not as I do”. If he TRULY believed inflation was coming, he would not have bought any of the fixed income securities he bought recently.
    Always be careful about what a “guru” tells you and ask yourself ” Would ths work for me too”.

  10. Canadian Capitalist

    Philip: As long as food isn’t wasted, a well-stocked pantry might be a good idea.

    LEB: Wish I had owned PCA 🙂 I’m hearing a lot about infrastructure and will be researching if a 5% weighting is warranted there. I already have 5% allocated to REITs but nothing so far to real return bonds.

    Ben: Great idea for a post. I see that 5-year mortgages can be had for 4.15% and variable rate at prime + 0.80% (or 3.3%). I agree that it doesn’t seem to be a wide enough spread.

    Phil: It would be interesting to see a core versus total CPI chart. I remember the opposite argument in the late 1990s — that core inflation overstates actual inflation. Any economists care to shed a light?

    Shawn: The mini portfolio is a relatively small portfolio. The Sleepy portfolio, which is larger has a 5% exposure to real return bonds through XRB. Since the mini already has a huge equity exposure, it should offer a good inflation hedge over the long term.

    DGI: Perhaps. Or perhaps Buffett thinks he’ll make good money on the preferreds as well as the warrants over time. I’m not making any changes to the portfolio because just last year the worry was stagflation, then we worried about deflation, now we’re worried about high inflation. Next year, we’ll be worrying about something else. If we make changes for every shift in wind, we’ll never anywhere with investing.

  11. I’ve recently been thinking of the concept of inflation, prompted by the discussion in “Your money or your life.” In it they argue that inflation as a risk to your money is a myth. Purchasing power often goes UP over time as technology improves. Buffet seems to echo that when he says that 15min of labour will by x now, and even if nominal inflation goes way up, 15min of labour in the inflated environment will likely still by x then.

    The way we measure inflation is a joke and includes so many items in its basket that aren’t reflective of normal life. If a fridge costs more now than it did 20years ago (not really true), it’s also true that it probably lasts a lot longer.

    I’m really questioning whether inflation IS a risk to assets.

    • Canadian Capitalist

      rm: I think maintaining and growing wealth in real terms is the main challenge for the long-term investor. I don’t think inflation risk is a myth at all. Inflation is especially a huge risk for traditional bonds which payout a nominal coupon. If actual inflation is materially different from expected inflation, the real returns from fixed income will suffer.

      Phil: Agreed. Esp. since we are talking about an annualized difference of 10%.

  12. There seems to be no way to edit…I meant so say BUY, not “by” when talking about what labor can purchase.

  13. Canadian Capitalist

    Phil: Here’s what I found on the BoC page:

    Core CPI = 87.9 in 1995; 112.8 today. Roughly 1.8% per year.
    Total CPI = 86.6 in 1995; 113.8 today. Roughly 1.97% per year.

    It does appear that total CPI is slightly higher than core CPI. Perhaps, good topic for a post.

  14. Hi CC. Although the overall numbers look small, 1.97% is bigger than 1.8% by about 9.4%. So, investment-wise in terms of real return bonds using core CPI, that’s quite a big difference! You’re ripped off by 9.4% off the “real” inflation rate…

  15. rm – you seem to argue that, if wages increase by inflation, your personal earnings power is a hedge against inflation. This seems accurate. However, inflation will definitely erode the purchasing power of the portion of your past wages you saved, unless your return after taxes and costs is equal to the inflation rate.

    The argument about improved technology does not apply to all elements of the inflation basket, certainly not food and energy (but perhaps refridgerators, plasma screens and laptops…

    I guess that over the long term the difference between core and total CPI is determined by the weighting and inflation of the components excluded from core CPI, which becomes a problem of predicting the future. In truth, every person experience a slightly different personal inflation, based on their lifestyle. CPI is just a measure of the average.

    Some time ago, CC did a post on US market data available from some professor. I can’t remember his name, but did have a look at it back then, and remember that there was a systematic pattern in the correlation of real equity returns and the inflation rate. In the short term, inflation decreased the real return, but the correlation between inflation and future real return increases systematicaly as the time period increases, and is strongly positive for 10 year periods, which was the horizon I stopped at. For a long term inflation hedge, my bet is equities then. In the short term – who knows?

  16. Pingback: Thicken My Wallet » Blog Archive » Are we heading back to $100 barrel of oil?

  17. Pingback: Weekly Blog Review-Follow me on Twitter | Financial Highway

  18. I’m a Realtor, so obviously I will be pro-real estate.

    That said, this blog post mirrors my thoughts exactly over the last 3-4 months.

    National gov’ts and central banks around the world pumping huge demand into economies will have an effect. Its going to reflate our economies, but inflation is going to come too.

    To prepare for inflation, I am locking into 5yr fixed mortgages (who ever thought we’d see 3.85% 5yr fixed mortgages!!) and saving as much as possible to buy more real estate.

    Inflation will affect rents first I think and then prices. With locked in 5yr mortgages under 4%, the cost of money goes to nothing while rents get pushed up by inflation. Prices will be affected next.

    I just hope we don’t see interest rates at or near 2-% as we did in ’81-’82

  19. I checked with the Bank of Canada and the inflation measure used by the RRBs is Total Inflation not Core Inflation. The terminology the info sheet pdf uses is “All-items” CPI.