For consumers, inflation can mean stretching a static paycheck even further, but for investors, inflation can mean continued profit as they add to their retirement portfolio.
Inflation is defined as a sustained increase in the price of goods and services. In an inflationary environment, a gallon of milk that once cost $3 may now cost $4. Over time, inflation erodes the value of a nation’s currency. There are a variety of factors that influence inflation and arguments about its root cause.
How Can Inflation Be Good For The Economy?
The Basics of Inflation
In economics, inflation is a quantitative measure—one of quantity over quality—of the speed at which the average costs for a standardized basket of goods increases over a specific period. Inflation measures the spending power of currency and most often will appear as a percentage.
Climbing prices are bad news for consumers, as it takes an ever-increasing amount of money to purchase the same basket of goods and services year after year. This concept is known as purchasing power.
A nation's monetary authority—such as a central bank—will work to keep the rate of inflation within a boundary that keeps the economy running and encourages growth. Some level of inflation is necessary as it promotes spending which helps national economic growth. The most common measurement tools used to rank inflation are the Consumer Price Index (CPI), and the Producer Price Index (PPI):
- CPI measures the weighted average a consumer pays for a standardized group of goods and is reported monthly by the Bureau of Labor Statistics (BLS). CPI measures finished products.
- PPI is a weighted average of prices for domestic producers at the wholesale level of production. It is also reported monthly by the BLS. PPI measures good at any stage along the production and output line.
Some nations will use WPI—which works in the same manner as does CPI but measures a basket used on the retail level—but the U.S. prefers to use PPI to measure inflationary pressures on businesses.
Many different factors contribute to rising prices. When the overall demand for goods build, supply prices will rise. Increases in the cost of production—due to everything from growth in the cost labor to rises in the cost of raw commodities. Most consumers view inflation as an adverse situation. However, inflation does have a positive side when looked at from an investment standpoint.
- Several asset classes perform well in inflationary environments.
- Tangible assets, like real estate and commodities, have historically been seen as inflation hedges.
- Some specialized securities can maintain a portfolio's buying power including certain sector stocks, inflation-indexed bonds, and securitized debt.
- Inflation-sensitive investments are accessed in a variety of ways as both direct and indirect investments.
Real estate is a popular choice not only because rising prices increase the resale value of the property over time, but because real estate can also be used to generate rental income. Just as the value of the property rises with inflation, the amount tenants pay in rent can increase over time.
These increases let the owner generate income through an investment property and helps them keep pace with the general rise in prices across the economy. Real estate investment includes direct ownership of property and indirect investment in securities, like a real estate investment trust (REIT).
When a currency is having problems—as it does when inflation climbs and decreases its buying power—investors might also turn to tangible assets.
For centuries, the leading haven has been gold—and, to a lesser extent, other precious metals. Investors tend to go for the gold during inflationary times, causing its price to rise on global markets. Gold can also be purchased directly or indirectly. You can put a box of bullion or coins under your bed if a direct purchase suits your fancy, or you can invest in the stock of a company involved in the gold mining business. You can also opt to invest in a mutual fund or exchange traded fund (ETF) that specializes in gold.
Many investments have been historically viewed as hedges—or protection—against inflation. These include real estate, commodities, and certain types of stocks and bonds.
Commodities include items like oil, cotton, soybeans, and orange juice. Like gold, the price of oil moves with inflation. This cost increase flows through to the price of gasoline and then to the price of every consumer good transported by or produced. Agricultural produce and raw materials are affected as well as automobiles. Since modern society cannot function without fuel to move vehicles, oil has a strong appeal to investors when prices are rising.
Other commodities also tend to increase in price when inflation rises. Some more advanced investors may wish to trade in commodities futures. However, all investors may gain exposure through a publicly traded partnership (PTP) that gains exposure to commodities through the use of futures contracts and swaps.
Investing in bonds may seem counterintuitive as inflation is deadly to any fixed-income instrument because it often causes interest rates to rise. However, to overcome this obstacle, investors can purchase inflation-indexed bonds. In the United States, Treasury Inflation-Protected Securities (TIPS) are a popular option. pegged to the Consumer Price Index.
When the CPI rises, so does the value of a TIPS investment. Not only does the base value increase but, since the interest paid is based on the base value, the amount of the interest payments rises with the base value increase. Other varieties of inflation-indexed bonds are also available, including those issued by other countries.
Inflation-indexed bonds can be accessed in a variety of ways. Direct investment in TIPS, for instance, can be made through the U.S. Treasury or via a brokerage account. They are also held in some mutual funds and exchange-traded funds. For a more aggressive play, consider junk bonds. High-yield debt—as it's officially known—tends to gain in value when inflation rises, as investors turn to the higher returns offered by this riskier-than-average fixed-income investment.
Stocks have a reasonable chance of keeping pace with inflation—but when it comes to doing so, not all equities are created equal. For example, high-dividend-paying stocks tend to get hammered—like fixed-rate bonds—in inflationary times. Investors should focus on companies that can pass their rising product costs to customers, such as those in the consumer staples sector.
Leveraged loans are potential inflation hedges as well. They are a floating-rate instrument, meaning the banks or other lenders can raise the interest rate charged so that the return on investment (ROI) keeps pace with inflation.
Mortgage-backed securities (MBS) and collateralized debt obligations (CDOs)—structured pools of mortgages and consumer loans—respectively, are also an option. Investors do not own the debts themselves but invest in securities whose underlying assets are the loans.
MBSs, CDOs and leveraged loans are sophisticated, somewhat risky (depending on their rating) instruments, often requiring fairly large minimum investments. For most retail investors, the feasible course is to buy a mutual fund or ETF that specializes in these income-generating products.
Pros and Cons of Investing for Inflation
There are pros and cons to every type of investment hedge, just as there are pros and cons with every type of investment. Also, there are positive and negative features to the various assets described above.
The primary benefit of investing during inflation, of course, is to preserve your portfolio's buying power. The second reason is that you want to keep your nest egg growing. It can also lead you to diversify, which is always worth considering. Spreading the risk across a variety of holdings is a time-honored method of portfolio construction that is as applicable to inflation-fighting strategies as it is to asset-growth strategies.
Preserve portfolio worth
Maintain income's buying power
Increase exposure to risk
Divert from long-term goals
Overweight portfolio in some classes
However, the inflation tail should never wag the investment dog. If you have specific goals or timetables for your investment plan, don't swerve from them. As an example, don't weigh your portfolio too heavily with TIPs if it requires significant capital appreciation. Also, don't buy long-term growth stocks if your need for retirement income is imminent. An obsession with inflation should never get you out of your risk-tolerance comfort zone.
There are no guarantees. Traditional inflation hedges don’t always work, and unique economic conditions sometimes deliver excellent results to surprising assets while leaving what seemed to be sure winners trailing in the dust.