How to invest when inflation is high

Predicting the inflation rate is difficult. There are so many variables at play—demographics, government spending, interest rates, economic growth, consumer spending, etc.—that it’s nearly impossible to pin down a single reason for higher prices at any given time.

However, right now we know there was massive fiscal stimulus because of the pandemic, supply chains are a mess and consumers have never been so flush with cash. When you factor in the pent-up demand from people being stuck in their homes without much to do in 2020, it was a perfect storm for higher prices.

While no one knows if above-average inflation is here to stay or for how long, investors are being forced to seriously consider the various ways they can hedge against rising prices in their portfolios for the first time in decades. This task is easier said than done.

For instance, gold is typically seen as a safe haven from inflation. If you’re a goldbug, the past 18 months or so had to be the ideal set-up for a rise in the yellow metal. There was a recession, a pandemic, massive government spending and low interest rates. However over the past 12 months, while the annualized inflation rate was over 6%, gold is actually down almost 2%. Gold’s 12 month return is -1.7%, which is just below the one year return of -1.4% for the aggregate U.S. bond market.

Bonds are another asset class that isn’t acting in the way you would expect with rising inflation. When economic growth and inflation are both moving higher, you would expect interest rates to move up as well. This makes sense from an economic textbook perspective because rates should move up to compensate fixed-income investors for the inherent inflation risk they’re taking. If inflation is higher than the yield you’re earning on your bonds, you’re technically losing money on a real basis.

The problem is that’s not happening this time around. Inflation is much higher than interest rates and we’re seeing a massive divergence between the two variables.

Short maturity bonds tend to be a great hedge against inflation. The idea here is as interest rates rise, you can reinvest your bond proceeds from maturing securities into new bonds with a higher yield. Only yields aren't cooperating this time. They're not moving meaningfully higher with the rate of inflation. There are a number of reasons for this divergence but this is another case of a textbook inflation relationship that's not working at the moment.

There are more traditional inflation hedges that are working in this environment. Commodities and energy stocks are both up big over the past 12 months.

Treasury inflation-protected securities (TIPS) are a bright spot when it comes to fixed income. These bonds automatically adjust their principal higher with the rate of inflation. So while the aggregate bond market is down almost 2% over the past year, TIPS are actually up almost 8% in that time from the inflation kicker.

These inflation hedges could continue to do well in the coming years. But making a huge portfolio shift into these asset classes means you're betting inflation will remain elevated for some time. This is certainly possible but it's not a given. An aging population and technological innovation could potentially counteract higher levels of government spending in the years ahead. And the pandemic could turn out to be a one-time influx of cash to households from the U.S. government.

There are two other long-term inflation hedges worth mentioning, regardless of inflation's path from here.

The U.S. stock market as a whole remains one of your best bets against rising prices over the long haul. Profits and dividends have both grown over and above the rate of inflation for decades. Since 1950, dividends have grown at 6% per year while profits are up more than 7% annually. Those growth rates are well above the roughly 3% annual inflation rate in that time. The stock market has worked well in the current environment as well. Large corporations have been able to pass along higher input prices to consumers in the form of higher prices for goods. Therefore, profit margins remain near all-time high levels.

The final piece to the inflation puzzle is owning a home. First of all, homes have tended to grow at or above the rate of inflation over the long-term. But the most advantageous aspect of homeownership when inflation is elevated comes in the form of a fixed-rate mortgage. Let's say your monthly mortgage payment is $1,500. Assuming a 3% annual inflation rate, in 10 years your payment would now be worth just $1,100.

How can this be?

Inflation works like compound interest but for debt, it shrinks your payments. So while you will be paying higher prices at the grocery store and gas pump during an inflationary environment, your fixed debt payments are deflating over time.

Predicting what comes next in the economy is never easy. This is true for inflation, economic growth, the timing of recessions and everything in-between. Regardless of the pace of inflation from here, there are assets that can protect you from rising prices. You just have to be able to think for the long-term to see those benefits.

Certain securities mentioned in the article may be currently held, have been held, or may be held in the future in the author’s personal portfolio or a portfolio managed by Ritholtz Wealth Management.