All eyes are on Federal Reserve Chairman Jerome Powell as he testifies before congress to explain about inflation and the Fed’s plans to deal with it. After all, the mission of the Fed is to foster the stability, integrity, and efficiency of the nation’s monetary, financial, and payment systems so as to promote optimal macroeconomic performance. This is the balancing act between full employment and price stability or inflation. While the average American may not understand quantitative easing or ways the Fed implements its policies, we all understand the effects of higher interest rates and rising prices.
Let’s begin by taking a look at what inflation is and determine if and how it is possible to profit during inflationary times. Inflation is basically a sustained increase of the price of goods and services. There are more detailed explanations given by economists in demand-pull and supply-push theories of inflation, but for the layman who goes to the grocery store it’s the fact that a loaf of bread which use to cost three dollars now costs four. This has the deleterious effect of eroding the value of the dollar over time. The level of inflation in an economy changes depending on current events. Many economists today will tell you our current inflation stems largely from the pandemic. Rising wages and unemployment at 2-year pandemic lows finds us with worker shortages in many of the leading industries. Shutdowns in the supply chain have caused a rapid increase in the price of raw materials and certain commodities such as oil and gas.
As with most investments it can be prudent to begin by taking a look at what the smart money is doing during changing economic times. You can be assured that the wealthy are in tune with rising inflation and will factor it in to their investment decisions this year. According to Michael Sonnenfeldt, chairman and founder of TIGER 21, 65% of its members expect inflation to accelerate in the next year. As such, wealth management experts are pointing their clients in the direction of these three main categories:
- Real Estate
- Specific Equities like Platform Companies
In regard to real estate as a hedge against inflation we are generally looking beyond your personal residence and into REIT’s, or Real Estate Investment Trusts. A REIT is a company that invests in different kinds of income-producing real estate (shopping centers, condominiums, housing developments, hospitals, parking garages, etc.). You can buy shares of the REIT in order to get exposure to its real estate investments and have that real estate be part of your investment portfolio without actually managing property yourself. The reason that real estate works as an inflation hedge is that rising prices increase the resale value of the property, plus rental real estate generates a fixed income which also rises as tenants’ rent increases.
When it comes to equities it can be a little trickier to adjust your portfolio to inflation. If you look at interest sensitive stocks like those big tech names of the NASDAQ you will see that they are prone to decrease in inflationary markets. The reason is the risk of increased interest rates. In general, these companies may have little or no income, with their value being based on future speculation. As such, they can’t rely on net income as a source of cash flow for growth, thus they turn to the credit markets that become more and more expensive as interest rates rise. This has the inverse effect on the stock price, driving it down as rates increase. However, you can still guide your equity dollars into some of these and others who are platform companies that have some ability to control pricing power. Not in an antitrust way, but companies like Amazon and Apple can control in some degree the price of their consumer staple products and streaming services among others. This makes them more resilient in periods of inflation.
We would be remiss if we didn’t mention investing in gold to combat against inflation. Yes, it is being tweaked in portfolios, but it is another alternative investment that is drawing the attention of the wealthy. You might not think it, but this inflationary economy has been shifting the wealthy into more and more cryptocurrencies. Crypto is not just the domain for the young and the Reddit, but also for the more sophisticated investor. So what are they investing in? Again, according to TIGER21, “Members are putting their money specifically in ethereum (34%), bitcoin (33%), a crypto fund (23%), other coins (15%) and dogecoin (2%). Unlike gold and its physical commodity property, Bitcoin and the others have yet to be tested to see if they are actually a good hedge during inflation. Bitcoin is often described as “digital gold” and theoretically should protect against inflation because of limited supply.
The categories of real estate, equities and cryptocurrencies that are being utilized by the ultra-wealthy can be put in most anyone’s investment toolbox as well. However, the wealthy are generally utilizing money that might be more available for risk. Depending upon your needs and time horizon you might only want to dabble in these areas or skip them all together. The core of your portfolio shouldn’t be radically altered, because there is no guarantee that inflationary hedges that worked in the past will correlate and work again.