Inflation Investments

With inflation being at its highest level since the 1980’s, the subject of rising prices and living expenses is on the mind of most people across the globe. Inflation in 2022 is certainly a global phenomenon, as nearly every developed country has been impacted by supply chain issues still lingering from Covid shutdowns, and even more recently exacerbated by the Ukraine-Russia war. In late 2021, it looked like supply chain issues were likely to slowly resolve over 2022, but unexpected energy inflation from the conflict in eastern Europe and new Covid shutdowns in Shanghai have thrown the global economy another curveball.

While the causes of inflation might seem far away to many, the effects are obvious to anyone shopping for groceries, buying a used car, or commuting to work. So how should the average person help protect and grow their assets during these periods? In this article, I’m going to outline four tips for dealing with inflation. Two are short-term strategies that focus on your cash and spending, and the other two focus on how to adjust your investments to outpace inflation over the long-term.

How much are you personally affected by inflation?

The most common way to measure inflation in the U.S. is the Consumer Price Index (CPI), which is a ‘basket’ of goods and services whose prices are calculated monthly. That ‘basket” includes costs of medical care, apparel, housing, transportation, food, education, recreation, and more. The CPI is a great metric to measure inflation, but it doesn’t necessarily say how if affects your household specifically. So, the first logical step for anyone trying to gauge the impact inflation has on their life is to estimate their personal inflation exposure. The CPI basket includes items whose costs vary wildly:

If you’re going to make changes to help combat inflation in your daily life, you need to figure out how much it’s affecting you. From the data above, it’s clear that commuters are likely going to be hit much harder than those that don’t travel much. So how can you estimate your personal inflation exposure? I recommend breaking down your monthly living expenses into categories (transportation, food, utilities, recreation etc.), then comparing your highest living expenses categories to the inflation categories above. If your largest monthly expenses are gas, electricity, and food, you’re likely feeling the full effect of inflation on your daily life. However, if you don’t commute and have low utility costs, its very likely that your experiencing inflation rates well below average.

How much cash should you hold during high inflationary periods?

For the past decade, interest rates in ‘cash’ accounts like money markets, savings accounts, and other safe investment vehicles has been near or below 1%. While interest rates are rising, there is very little reason to hold more cash than necessary during inflation periods. I currently recommend two income families to hold 3-6 months of living expenses, and one income families to hold 6-9 months of living expenses in cash. Obviously, this is going to be influenced by your current situation. For example, people saving for a house down payment are obviously going to be holding a larger cash fund. It’s important to clearly identify the short-term goals you have for your cash, and make sure that you’re not holding onto excess if there is no clear goal for that money. If inflation is 8% this year, and you lost 5% in the stock market, you are still ahead compared to holding cash! Paying down high interest rate debt, or purchasing government issues I-bonds through treasury direct are also great options.

Stocks are one of the best assets to outpace inflation over time

It might seem counterintuitive that stocks are a solution to fighting inflation when the stock market has suffered in 2022 because of inflation. However, the current spike in inflation is likely short-term in the grand scheme of things, and over the long term, stocks have proven that they can outpace inflation. As you enter retirement, one of the biggest threats to the success of your financial plan is inflation eroding your purchasing power, and your investment portfolio not providing enough income as costs increase. The consistent 7%+ returns generated by the stock market have traditionally offset inflation and should continue to do so over the long-term. This is even more important for projections that show elevated inflation over long time periods. Trying to live off only cash and bonds when inflation is sustained at 3% for a decade is a losing proposition.

Consider TIPS, I-bonds, and Real Estate

The classic thinking around inflation hedges suggests that gold and commodities will do well as the value of the dollar declines, which is similar to what is happening during high inflationary periods. Commodities and gold are fixed supply assets and are theoretically supposed to keep their value because of limited supply. However, going back to high inflationary periods (e.g., the 1970’s) reveals that both gold and commodities underperform stocks during these periods, and don’t offer much to gain as an inflation hedge.

However, Real Estate (publicly held as Real Estate Investment Trusts) has historically outperformed stocks during periods of high inflation, and in my experience offer the best option as an inflation hedge in most portfolios. Treasury Inflation Protected Securities (TIPS) are government bonds whose value and regular interest payments are linked to the rate of inflation. While they aren’t going to provide the types of return that equity can, they are certainly a great asset for providing protection and hedging against future unexpected inflation. At Arrow, we advocate that a strong stock portfolio with real estate and TIPS exposure is the best way to weather high inflation environments over the long term.