Preparing for Inflation: A Review Post of Rational Reminder Podcast 150
My Initial Thoughts
Way back in the 1980s, when I was younger … and the earth was still cooling … inflation was running hot. I had a small student loan at the time, about $5,000 as I recall. The interest rate on that loan was 13%. These days a student loan is typically in the 2.5 – 3% range. A few years later, in 1990, when we had some extra money and the interest rate available on savings accounts was relatively low, we bought a money market mutual fund – our household’s first foray into investing. The interest rate on that fund was 9%. The equivalent rate on that fund today is 0.05%. When we first bought a house, in 1996, the interest rate was 7.5%. Today, one of the big banks has a 5-year fixed rate of 2.44% and no doubt you can do better than that if you shop around.
This is all to say that, although the interest rate environment in Canada has been on a steady decline, along with the decline in inflation, the I-word, inflation, is not unknown to many Canadians. And it seems to many that inflation is making itself known again. I’m not so sure about that. I am inclined to believe that central banks around the world have learned a lot about controlling inflation in the last 40 years or so, and fears about inflation may be overblown. Nevertheless, the question arises, what can an investor do to hedge against the risk of inflation? To begin with, here are some of my thoughts.
Cash and Cash Equivalents
As I mentioned above, back when inflation rates were well above the current Bank of Canada target rate of 2%, you could get a money market fund paying 9 percent. Interest rates on Money Market funds, savings accounts and Guaranteed Investment Certificates (GICs) tend to move with inflation. In 1990, you could get a 5-year GIC with an 11 percent return. This suggests to me that even though GICs and other cash equivalent investments pay poorly now, they are an option to consider if inflation begins to pick up. If you set up a GIC ladder, that is, buying GICs with maturities of one through five years in the same or similar proportions, you will always have a GIC maturing each year, giving you the opportunity to lock in a high interest rate for at least some of your money.
Real Return Bonds
At least two ETFs and several mutual funds allow an investor to gain access to Canada’s real return bond (RRB) market. RRBs are sold mostly by the Government of Canada, although there are a few sold by provincial governments. Unlike standard bonds, RRBs will adjust their principal by the increase in the Consumer Price Index (CPI). To provide a simple illustration of how this works, let’s suppose you own $1,000 of an RRB, that pays interest at 5%. Every year you will receive $50 in interest payments ($1,000 x 5% = $50). Now, let’s suppose inflation, as measured by the CPI, rises by 10% in a given year. That means that the principal will be adjusted upward by 10%. Your $1,000 principal will now be $1,100 and your 5% interest payment will be based on that $1,100, which means your yearly interest payments will equal $55 ($1,100 x 5% = $55).
Personally, I’ve never bought RRBs, either directly or through a fund or ETF, because they seemed rather complicated and we’ve mostly experienced a general decline in interest rates, making them not that helpful. But, if inflation is going to ramp up, maybe they are worth looking into.
Inflation is a mixed bag for equities (stocks) as I understand it. On the positive side, owning shares of a business is positive for the investor, because businesses have the freedom to raise prices to match their increasing costs in an inflationary environment. On the other hand, as inflation goes up, investments in less risky assets like cash or cash equivalents becomes more attractive as the rates from such intruments go up. This leads to investors choosing the less risky investment, and as money leaves the stock market for higher yielding cash equivalents, demand for stocks declines, driving prices downward. My view: stocks go up and down but if you own a well-diversified equity portfolio, you’ve probably done the best you can to protect yourself against inflation. I would be extremely hesitant to get out of the stock market altogether.
Research from the Rational Reminder
If you want to listen to a podcast with solidly researched observations on investing for Canadians, you could hardly do any better than the Rational Reminder podcast. Comedy duos seem like a thing of the past, but if I were to liken the two hosts to a comedy duo Cameron Passmore is the straight man who sets up the scene while Benjamin Felix is the comic who delivers the punchline. Well, he’s the comic if you like comedy that is cool, rational, carefully researched, and willing to challenge the conventional wisdom.
Passmore and Felix titled their latest episode “The Ultimate Inflation Hedge” (see, comedy gold right in the title). They begin their discussion of inflation by pointing out that, while central banks do not want high inflation, an even worse scenario is deflation, which is why, in the wake of the COVID-19 pandemic, you have seen interest rates drop to lows that have not been seen for decades.
The second thing to observe is that the current prices of investments have inflation expectations already “baked in.” The important thing to note here is the word “expectations.” Prices take expected inflation into account. But the fear, if you will, is in unexpected inflation. So, how do you hedge – protect yourself – against unexpected inflation? Felix then goes on to examine several suggested alternatives.
Real Return Bonds
Felix begins his examination of potential hedges against inflation with real return bonds (RRBs) or, as they are known in the US, Treasury Inflation-Protected Securities (TIPS). One of the big issues with RRBs, though, is that they are only a suitable hedge against inflation if your investment horizon matches the maturity of the bond you are purchasing. RRBs in Canada are generally long-term bonds. The two ETFs in Canada that hold RRBs, XRB in the iShares family, and ZRR from the Bank of Montreal, have weighted average maturities of about 18 years. Although inflation can stretch out for a long time, it is more often a short-term phenomenon. And, in the short term, as with any long-term fixed-income product, there is still a lot of uncertainty about how RRBs will respond.
Cash and Cash Equivalents
As an alternative to RRBs, Felix suggests that cash equivalents may be a better choice. As interest rates go up, rates on short-term instruments like high-yield savings accounts and GICs have the potential to increase their returns along with the increase in short-term yields. While not perfect, over long periods of time, short-term investments like treasury bills and short-term government debt have been pretty good at keeping up with inflation.
Several years ago when I worked for a US discount brokerage of a Canadian financial institution that had offices here in London, ON, one of the services offered was “Canadian trading.” This service gave US resident clients the ability to invest in Canadian stocks in Canadian dollars. The people most interested in this service were “gold bugs,” people who are particularly enthusiastic about the virtues of gold as an investment. Emphases differ, but gold bugs generally believe that so-called “fiat currency,” money that is not backed by a physical commodity, is literally “not worth the paper it’s printed on.” They worry that government policies will undermine the value of money and cause inflation. Gold is the only proper hedge against impending economic disaster in the gold bugs’ view.
Felix’s review of gold’s performance as an inflation hedge reveals that it might be effective … if your investment horizon is measured in centuries. Over shorter time frames – less than hundreds of years – gold provides unreliable protection against unexpected inflation.
One of the other interesting beliefs is the assertion among gold aficionados of something called The Golden Constant, in which gold maintains its purchasing power over the long run, again measured in centuries. Felix cites the paper “The Golden Constant” by Erb and Harvey. These authors estimated what this golden constant should be if gold maintained its purchasing power over the centuries. Interestingly, they estimated that in 2016, when the paper was published, gold was priced well above its estimated constant value. Given that gold prices are quite a bit higher now than they were in 2016, it is reasonable to believe that gold continues above its constant value and that we should expect it to decline. A final observation to point out is that the golden constant suggests that gold only matches inflation. In other words, there is no expectation of a positive real return.
Although the world’s economies are becoming more integrated over time, just because one country is experiencing inflation, that does not mean all other countries will have inflation, too. High inflation in Canada does not necessarily mean high inflation in Europe or Japan. Inflation can have a negative impact on stock returns but there are multiple reasons why a given country’s stock markets may have better or poorer returns. Therefore, global investing outside of Canada is not necessarily a reliable hedge against inflation. Nevertheless, just as diversifying beyond Canada is a good practice to mitigate the avoidable risks of equity investing, global investing also helps mitigate the risk of inflation in our domestic economy. Felix points out that from 1966 to 1982, the US stock market had positive nominal returns, but when inflation was accounted for the real return was effectively zero over that period. However, during that same period, both Canada and the UK, to name two countries, had positive real returns. In other words, American investors would have done well to have invested beyond their own markets. The same applies to investors in every country of the world today.
The bottom line: Benjamin Felix concludes that there is no perfect hedge against inflation. This is absolutely unsurprising. The inevitable answer is to invest in a broadly diversified portfolio of stocks from Canada and around the world, and add in fixed income and cash equivalent investments appropriate to your circumstances. Although not a perfect hedge, you will be as well prepared as you can be to protect yourself against inflation.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.