With the latest Consumer Price Index Report (CPI) coming out and people seeing an overall increase from April 2020 to April 2021 of 4.2% for all categories, 2.4% for food, 25.1% for energy, and 3.0% for all without food/energy.
I think the one that is most skewed would be energy as we have to remember in April of 2020, we we’re entering a pandemic and the demand for oil crashed. So while the amounts are higher now it’s just important to have that slight asterisk next to that item.
Nonetheless the numbers are higher than normal and I think it probably does have to due with the massive increase in money supply.
What may have caused this spike in the inflation?
Well for one our government did print a ton of new dollars into the system as a whole (M2 money supply). As seen by the graphic below, after Covid the government stepped in to curb the downside effects of the economy crashing.
In order to keep everything from free falling, the fed started to quantitative easing through the purchase of treasury bonds. This buying of government bonds in turn increases the money supply in the economy to spur spending and investment.
If the money supply continues to expand, it makes sense that the money people own become less valuable and purchasing power goes down via inflation.
Investors may be wondering how does one hedge against inflation in their portfolio. So let’s talk about some sectors that do well during higher inflationary periods. When this happens, the fed tends to go into a monetary policy to raise interest rates.
If you think about goods from oil to corn, the pricing of these are all valued in USD.
While the pricing of commodities can be dependent on supply and demand it does show a positive correlation to CPI over a long period of time. Based on the following research at NN investment partners, there is a 3.5% increase in the Bloomberg Commodity Index for around every 1% raise inflation.
So this correlation shows that over time through different economic cycles, that it is a great hedge versus inflationary pressures.
My portfolio play: I own stocks like Nucor (NUE) which is a steel producer along with an ETF like VDE (Energy – Vanguard ETF) which is a play on the oil industry. Both of these stocks have direct pricing exposure to the commodity markets. As the pricing of the commodities they produce and sell rise with inflation, their revenues and therefore profits rise.
Another asset that appreciates to keep up with inflation is home prices as seen by the graphic below.
Another benefit of owning real estate is you can use leverage to borrow money to buy into real estate to keep up with inflation.
Then over time the real value of that debt actually decreases because the future debt payments are in dollars worth less than when you signed up for the debt itself.
My portfolio play: I currently don’t own any personal real estate, but in my portfolio I own VNQ (Vanguard ETF – Real Estate). This is a Real estate investment trust (REIT) which owns a portfolio of real estate assets and I own part of that portfolio. While I am not using leverage to amplify returns, this is also a passive way to get exposure to the real estate market.
With fears around inflation, the Fed tends to implement a tightening of fiscal policy so they will do things like raise the federal funds rate.
Currently the rates are 0.25% which commercial banks borrow and lend their excess reserves to each other overnight.
With that rate so low, companies have access to cheaper debt and are more likely to invest to expand the business and grow. If the rates are increased, then debt become more expensive and companies are less likely to invest heavily in companies.
Now when rates are higher it actually is better for bank stocks because it shows signs of a strong economy so companies are less likely to default on loans. Also with higher rates, they can charge a higher % of the loans they are handing out. So if someone or a business deposits money into the bank, the bank can turn around and lend it out at a higher rate than they previously could with lower interest rates.
This expansion of the spread can lead to higher profits at these banks.
My portfolio play: I currently own companies like JPM, BAC, and ALLY as they will benefit from higher interest rates allowing them to make more interest related income.
One Surprising Fact
Believe or not gold is not historically proven to be an inflation hedge even though that is a common thought. Since 1971 the correlation between gold and inflation is only 0.28.
While there has been years where gold does go up with inflation, there are also years where it is the opposite. Gold still is more of a sentiment play and it’s perceived value along with use cases outside of just a store of value. Personally I don’t have any gold related plays in my portfolio. What I would consider the closest investment of mine to gold is bitcoin which has been called “digital gold” in the investing world.
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