Financial Poise
Investing in a High-Inflation Environment

Investing in a High-Inflation Environment

We started warning our readers about rising inflation more than a year ago (you can read what we had to say about it in our newsletters from March 2021: Inflation on the Horizon & An Uncertain Stock Market and Hedge Your Bets Against Rising Inflation)

Now that the inevitable (and it was inevitable, even then) has happened, what can you do?

Which Asset Classes Benefit from Inflation and Which Ones Don’t

Aim to accumulate assets that should withstand inflationary periods and avoid investments that fail to keep up with inflation rates. Real estate is a popular asset of choice for experienced investors. Cash is a notable example of an asset class to avoid, if possible.

Cash

Sitting on wads of cash in a savings account has never been an effective hedge against inflation; a more effective strategy would be to accumulate hard assets that can withstand periods of high inflation. Currently, the annual inflation rate is 8.3% for the 12 months ending April 2022 and the rate is steadily increasing. If you are trying to protect your nest egg against inflation, then saving cash is counterproductive as the US Dollar is losing purchasing power and the interest earned on savings is not on par with inflation.

Holding too much cash in savings is an often-overlooked risk as money loses its value during inflationary periods. Most investors are aware of this fact. However, the risk is often understated, especially if your retirement plan is cash dominant and not generating any income. In times of uncertainty, it makes sense to ‘side-step’ the market and hold cash, but for the most part, the value of cash savings erodes over time.

Series I Savings Bonds

Anyone with the cash to do so can buy as little as $25 and as much as $10,000 of Series I Savings Bonds each year (plus up to $5,000 using one’s federal income tax refund).

So what? Well, it’s a good deal, especially for someone who cannot afford to lose any of the principal amount invested or who is otherwise risk-averse (since I bonds are debt obligations of the U.S. Government and are thus backed by its full faith and credit).

The interest rate pays a combination of a fixed rate that stays the same for the life of the bond and an inflation rate that is set twice a year. For bonds issued from November 2021 through April 2022, the combined rate was 7.12% and readjusted to 9.62%.

I bonds earn interest for 30 years unless you cash them first. You can cash them after one year. But if you cash them before 5 years, however, you lose the previous 3 months of interest. For example, if you cash in an I bond after 18 months, you get the first 15 months of interest.

Interest is earned on the I bond every month and is compounded twice each year. And twice a year, the interest the bond earned in the previous 6 months is added to the bond’s principal value. Then, interest for the next 6 months is calculated using this adjusted principal. You get paid both your principal back and all the interest earned when you cash the I bond. You have to pay federal income tax on the interest, but not state or local income taxes.

You can give an I bond to as many people as you like since the purchase amount of a gift bond counts toward the annual limit of the recipient, not the giver. So, in a calendar year, you can buy up to $10,000 in electronic bonds and up to $5,000 in paper bonds for each person you buy for.

You can buy I bonds directly from the United States Treasury.

Commodities

Past performances of assets in inflationary environments can give some guidance to investors. And in the past, commodities have performed well in high inflation periods. The energy sector, for example, does spectacularly!

According to a study of the inflationary periods from 2000 onwards conducted by Wells Fargo, investments in oil alone produced a 41% return, and gold returned 16%. While some asset classes perform best in a stable inflation environment, others perform best in higher-inflation environments, and gold is one of them.

The prices for raw materials like gold (and other precious metals), agricultural produce, and oil usually rise with inflation and are good hedges against inflation. They can be a good alternative to real estate, which can be a costly venture inaccessible to the average retail investor just getting started. That said, trading commodities is risky. The prices for commodities are driven by supply and demand, which is unpredictable. Hence, investing in commodities is very difficult.

Green Investing Can Lead to More Greenbacks

“If you think inflation is bad, wait until the rest of the commodity markets really heat up. Although prices for basic materials like copper, aluminum, nickel, and steel—used to build everything—have already inflated, they haven’t yet escalated as much as fuels and energy-driven commodities like food. But they will if European and U.S. policymakers have their way. Buckle up.”

This is how Mark P. Mills began his commentary, The Coming Green-Energy Inflation, in a recent edition of The Wall Street Journal. Just one example, also cited by Mills: the average electric vehicle “contains about 400 pounds more aluminum and about 150 pounds more copper than a conventional car.”

The takeaways? First, the Green movement in the short term will contribute to inflation. Second, you may want to invest in copper, aluminum, and the other natural resources that are essential to making the world more “Green.” Think: cobalt, graphite, iron, lithium, manganese, nickel, polycrystalline silicon, and steel. These are the things needed to manufacture EVs, solar panels, and wind turbines.

The Green Movement, in the short term, will contribute to inflation. Therefore, you may want to invest in copper, aluminum, and other natural resources essential to making the world greener. Think cobalt, graphite, iron, lithium, manganese, nickel, polycrystalline panels, and wind turbines.

Real Estate

A competent financial advisor tells their clients to maintain a diverse investment portfolio regardless of whether there is surging or stable inflation. If that isn’t obvious to you, you should read Investing Basics for Beginners Installment #3: Never Put All Your Eggs in One Basket. Regardless of the state of inflation, one asset class worth your consideration is real estate. Traditionally, real estate has done well amidst rising inflation as property values rise with inflation. An owner of real estate with tenants can charge more for rent and, in turn, increase their income.

Investing in real estate can be highly rewarding if you play your cards right. The primary hypothesis is that real estate should be a hedge against inflation because it uniquely combines increasing income, appreciating value, and depreciating debt. Plus, one gets an added bump from the “psychology of the crowd.”

Because there are so many different sub-classes of the real estate asset class, it would be foolhardy to simply decide you will invest in ‘real estate.’ Rather, you should take the time to understand the various options.

[Editors’ Note: If you are considering investing in Real Estate, you may be interested in reading Challenges and Crisis in the US Farm Sector  or The Advantages and Disadvantages of Single-Tenant vs Multi-Tenant Investment Properties]

There’s Nothing Greener Than Farmland

The reach of Russia’s war on Ukraine extends much farther, and further, than the immense loss of life and the destruction of the way of life of the Ukrainian people, the war has already caused food shortages well beyond Ukraine’s borders.

Ukraine is known for being immensely fertile, and as one of the world’s largest producers of wheat and sunflower oil, the country is rightfully nicknamed the “Breadbasket of Europe.” Also blessed with deep seaports, Ukraine was, at least pre-war, one of the three largest exporters of grain on Earth.

“War in Ukraine sparks concerns over worldwide food shortages,” France 24 reports, which can already be observed with food shortages in Ukraine as well as North African countries such as Egypt, Tunisia, and Algeria, and in the Middle East. There is a particular concern for countries in the Global South that cannot endure the rising price of wheat. “The UN Food and Agriculture Organization (FAO) estimates that an additional 8-13 million people worldwide face undernourishment if food exports from Ukraine and Russia are stopped permanently.”

The emerging global food crisis and shortages of wheat are aspects of this war that some have yet to consider. Another source further states, regarding FAO’s estimation of the impact of food shortages:

“What they do not even mention is the shortage of fertilizer. Both [wheat and fertilizer shortages] together threaten a continental-scale famine where that number of eight to 13 million new people facing hunger is probably 10 times that.”

Russia and Ukraine combined are the exporters of 28% of the world’s fertilizer, and the disruption of the war has led the price of fertilizers to skyrocket.

What might this development mean for U.S. investors? Well, just as Walter Brooke gave a young Dustin Hoffman one word of advice (“plastics”) in 1967, Financial Poise has been speaking out since its founding about the benefits of farmland as an investment.

Since the 1980s, farm real estate has increased at a steady rate, and data from 2000-2010 reveals that this asset has retained its value. New data supports the notion that the value of farmland is increasing, revealing a 5.7% increase in the value per acre from just 2020-2021, with an overall increase of 4.4% over a 20-year period.

Back in 2010, there were already predictions that we would see the need for massively more food production:

“‘Demand for food is soaring. The world has consumed more food than it has produced in nine of the past 10 years,’ [according to] Susan Payne, chief executive of agricultural investment firm Emergent Asset Management. Another billion mouths to feed will probably be added in the next 15 years. ‘We expect to see a resource war around 2020,’ says Ms. Payne.”

That last sentence has, unfortunately, proven remarkably prescient.

The impact of the war has already started affecting the world on a global scale, causing a strain on resources to cultivate and export heavily demanded products. And while farmland remains relatively illiquid as compared to publicly traded securities, it is becoming far more liquid than ever before for the very reason that the asset class is growing in demand.

If you have an interest in farmland you will want to consider what sort of farmland to invest in. And if you are not interested in farmland but are interested in “farm-adjacent” investing, the food and grocery market is a $12 trillion industry that may attract your attention. Either way, consider whether environmentally friendly investing may be the way to go.

[Editors’ Note: For more on the investment thesis, read the article, Can You Get Wealthy Buying Farmland as an Investment?  If you are interested in other forms of green investing, you should read The ESG Investor and the Food Revolution: Embracing a Plant-Based Diet to learn more about such opportunities. And if you like the notion but would prefer to invest in publicly traded companies, we direct your attention to Sustainable Funds Are Off to a Rough Start to the Year.]

What About the Stock Market?

All else being equal, the stock market tends to perform worse as interest rates rise. Why?

Because as interest rates rise, the cost of borrowing goes up. So, it becomes costlier to borrow money. This is true for companies (even the most stable companies commonly borrow money in the course of their normal operations), and also true for consumers.

A company that must pay more interest to borrow money is not going to be as profitable as it would be if it paid less in interest. Consumers that have to pay higher interest on their credit cards are more likely to start spending less. When consumers spend less, companies sell less. And when companies sell less, they usually are not as profitable.

If you want to understand this stuff, really understand it, watch How The Economic Machine Works by Ray Dalio. It will take you 30 minutes.

Picking Specific Stocks in a High Interest Environment- Pricing Power is Key

From The Library of Economics and Liberty (Econlib):

“Demand for a good is said to be “elastic” if a small change in price causes people to demand a lot more or a lot less of the good. Demand for a good is “inelastic” if a small change in prices causes people to make no change or almost no change in how much they demand of that good…”

Usually economists describe demand as either relatively elastic or relatively inelastic when compared to an imaginary neutral amount of elasticity. That is, if a 10% increase in price results in a 10% decrease in the amount of the good demanded, we think of that as a neutral elasticity of demand. If we know demand for gas is relatively inelastic, we can estimate that when the price of gas goes up by 10% people will not change their buying habits very much, buying almost the same amount of gas as before–that is, reducing their gas purchases by less than 10%. If we know demand for gas is relatively elastic, we can estimate that a 10% increase in the price of gas will cause the quantity of gas demanded at the pump to fall by over 10%…

So, to say a company has “pricing power” is the same thing as saying its goods or services enjoy demand that are relatively inelastic.

Taking the lesson a step further, some companies within a given industry may sell more of what it has to sell during inflationary times. For example, as prices go up generally and it becomes too expensive for people to eat at more expensive restaurants, some of them may choose to go to less expensive fast food restaurants.


[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure and each includes a comprehensive customer PowerPoint about the topic):

This article was developed from a Financial Poise Weekly newsletter sent on April 21, 2022]

©©?2022. DailyDACTM, LLC d/b/a/ Financial PoiseTM. This article is subject to the disclaimers found here.

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