Stocks have really taken a hit this past month with all three U.S. indices S&P 500, DJIA, and Nasdaq 100 peaking in late April / early May. Fortunately since then, stocks have recovered somewhat but there still seems to be an overhang in the market and investors are still cautious.
What triggered the initial market sell off? In one word, inflation. Or rather inflation expectations to be more accurate since the stock market is forward-looking.
In April 2021, U.S. inflation rate as measured by Consumer Price Index (CPI) increased by 4.2% yoy, the fastest since 2008. Since the Federal Reserve has made known that their inflation rate target is 2% per year before they consider changes to monetary policy, you can imagine how April’s CPI numbers have stocked fears of inflation.
Some in the media have even gone so far as to warn about the risk of hyperinflation, which just means extremely rapid, excessive, and out-of-control price increases typically above 50% per month.
In my opinion, I highly doubt the U.S. will suffer hyperinflation but high inflation above 2% is definitely not out-of-the-question and something savvy investors should be prepared for.
Should inflation exceed 2% persistently, we could see the Fed react by raising interest rates (tapering) to try to keep inflation in check. This might results in another stock market sell off a.k.a. taper tantrum, especially in growth stocks which are long duration assets like what we have seen over the past month.
If you are worried about inflation, here are some investments you could consider to protect your portfolio against inflation and rising interest rates:
- Commodities
- Real Estate
- Stocks
- TIPS
- USD (for foreign investors)
Commodities
The most logical one is commodities, since it is the ingredient for almost all consumer products. If the price of commodities increase, so would consumer prices as companies pass the cost increases to consumers.
So if the price of your petrol increases, why not just own underlying commodity, oil.
There’s a wide range of commodities one could own. These could be energy products like oil or natural gas, agricultural products like wheat, sugar or coffee, or metals like gold, silver or copper (this list is not exhaustive).
The difficulty for most investors is accessing these commodities. Most commodities are traded as futures contracts which are more complex products probably not suitable for average investors.
A more accessible way would be to invest in a commodity ETF like the Invesco DB Commodity Index Tracking Fund (ticker: DBC). This is still a risky investment though since the underlying assets are futures contracts.
Alternatively, investors could look buying the shares of commodities-related companies. Established ones include ExxonMobil (ticker: XOM), Barrick Gold (ticker: GOLD), Rio Tinto (ticker: RIO) and Archer-Daniel-Midlands (ticker: ADM).
Real Estate
Housing is another component used in calculating CPI. As the economic cycle improves and wages increase, people will have more money to buy or upgrade their home and corporations will be more willing to spend on office or factory space.
Thus, investing in real estate might be a good idea to take advantage of increasing prices.
Interestingly however, since the Fed is likely to tighten monetary policy if inflation rises substantially, higher interest rates on property loans would make them more expensive. This could also dampen demand for real estate as less people a would be willing to take out loans.
If you want to invest in real estate but don’t have the large capital required upfront, you could consider investing into real estate investment trusts or REITs. REITs basically pool investor funds to buy large real estate assets. The REIT manager will then rent out the property and return steady rental income to investors in exchange for their capital.
Alternatively, you could also invest in a REIT ETF like the Vanguard Real Estate ETF (ticker: VNQ), which holds a diversified portfolio of REITs.
Stocks
Investing in stocks may sound counterintuitive in view of the recent sell off sparked by inflationary fears. However, we need to keep in mind that although short-term inflation has been rising due in part to supply shortages, the market is also anticipating longer term inflation as business improves as the worlds emerges from the pandemic. Stocks also have historically outpaced inflation in the long term. In fact, the whole point of investing in stocks is to beat inflation!
This would benefit many businesses and since stocks are part ownership of businesses, stocks should increase in value as well.
Of course there are many types of businesses and not every company is created equal. Investors should focus on high quality companies with low/no debt and highly in-demand products or services. Should inflation hit, these companies would be more able to pass on price increases to consumers. A light debt load would also means these companies will be less affected when interest costs increase due to higher interest rates.
Besides commodities-related companies, other sectors that stand to benefit from inflation and rising interest rates are financials and consumer staples. Companies that come to mind are JP Morgan (ticker: JPM) and Procter & Gamble (ticker: PG).
TIPS
Treasury Inflation-Protected Securities or TIPS are basically Treasury bonds indexed to an inflationary gauge. The principal value of TIPS increases with inflation, thus protecting investors from the decline in purchasing power of their money.
Bonds typically don’t perform well during periods of rising interest rates means rising bond yields. That means lower bond prices since bond prices move inversely to bond yields. TIPS seems to be one of the few exceptions particularly when inflation is rising.
If you insist on buying bonds then TIPS may be a good option. For younger or more aggressive investors, this may not be your cup of tea, since TIPS and bonds in general do not provide much capital appreciation. TIPS maybe useful for income investors or for portfolio diversification, but it vastly underperforms the S&P 500 index in the long term.
Instead of investing directly in TIPS, you could also invest in a TIPS ETF like the iShares TIPS Bond ETF (ticker: TIP).
USD
If indeed inflation triggers the Fed to tighten monetary policy and increase the fed funds rate, that would be positive for the U.S. dollar since higher yields attract more foreign capital to the U.S.
For investors based outside the U.S., holding USD or USD-denominated investments could offset any investment losses when taking into account foreign currency exchange.
Since I’m based in Singapore for example, I might consider increasing my exposure to U.S. stocks instead of local Singapore stocks. If USD strengthens against SGD, the forex gains would help to offset any investment losses on my U.S. stocks.
Conclusion
Regardless whether you believe that we will start to see persistent inflation or that this recent spike in inflation is temporary, as investors we should consider the merits of including some form of inflation protection into our portfolios.
In my view, stocks should still be the bulk of the portfolio. However, that doesn’t mean that we should ignore the threat of inflation and higher interest rates. The stock market and economies in general move in business cycles.
Since we have been in a low inflation, low interest rate, low economic growth environment for such a long time, it might just be a matter of time before the trend reverses. The question is when.
I’m definitely not an expert nor a financial advisor, but I do want to set up my portfolio to be able to withstand most, if not all market conditions since I’m in it for the long haul.
Are you preparing your portfolio for inflation and rising interest rates? If so, how? Let me know in the comments.
Disclosure: I’m long VNQ and JPM.
Disclaimer: This is not financial advice. I am not professional financial advisor nor do I work in the finance industry. Anything I write here is purely my personal opinion. Please do your own research and due diligence before investing into anything. All investments come with associated risks. Best to consult a financial advisor if you’re still unsure.