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How investors can protect against inflation

A common topic among investors is how to protect asset values and incomes while inflation is rising. The major asset classes: stocks, bonds and cash, do not immediately appear to offer a direct hedge against the impact of rising prices, leading some to consider more esoteric assets such as commodities, real estate and Treasury Inflation Protection Securities (TIP’s.)

In the years prior to the 2008 Great Financial Crisis (GFC), free markets had much greater influence in setting interest rates. In the absence of government interference, the price of money, like any other commodity, is determined by the intersection of supply and demand. However, that all changed in the years subsequent to the GFC.

Common sense tells us that any rational lender would require their loan to be paid back with a rate of interest which at least equals inflation. Why would anyone lend money at a rate where the lender receives less inflation-adjusted dollars at maturity?

After 2008, the US Federal Reserve and other major central banks around the world dramatically disrupted the free markets by artificially setting their base interest rates far below prevailing inflation levels and, in fact, to zero.

What was originally designed as a temporary fix for a damaged financial system became more permanent. For the majority of the past 14 years, the world’s most important interest rate has been set near zero and even negative in the case of Europe.

We are currently experiencing a sharp rise in inflation. The US consumer price index (CPI) has increased from an annual pace of 1.67% a year ago to a forty-year high of 8.50% last month. Overly zealous fiscal policies, supply chain disruptions, tight labour market conditions and excessive money printing can all be blamed, to varying degrees.

Meanwhile, investors are getting stiffed. Presently, the average money market fund pays less than 0.50% and that means investors either unwilling or unable to take capital market risk are guaranteed to lose money against inflation, in a big way.

Most bonds have, unfortunately also been more or less a losing proposition over the past year. While investment grade fixed income in today’s market offers higher interest rates than money markets, these rates are still below inflation. A five-year US government bond pays about 2.7%.

With bonds and money markets lagging inflation levels, that leaves equities as the best hope for an inflation-beating outcome. Unfortunately, however, not everyone has the fortitude and requisite time horizon to withstand the vicissitudes of the risk markets; and this year, volatility has been especially pronounced.

For example, year-to-date equity market volatility, as measured by the VIX index, has averaged about 25 compared to 19.6 for all of last year, a 27% increase. In the five years prior to the pandemic, the VIX index averaged just 15.

On a year-to-date basis, stocks as measured by the S&P 500 are down 7.4%, bonds are down 8.4% using the Bloomberg Aggregate Bond index, and money market fund rates, although getting better, remain well below inflation. Only commodities, up 33.5% so far, are in the green. And that begs the question of whether it’s worth considering commodity exposure.

Oil and gas are by far the largest components of market-weighted commodity indices. The energy crisis, caused by a variety of factors including the Ukraine war, sent oil above $130 per barrel in early March, the highest level since 2009. The average national price for gasoline recently hit an all-time high $4.33 per gallon, up more than 60% over the past year.

Wall Street sees further commodity price increases ahead. A recent report by J.P. Morgan suggests commodities could surge by as much another 40% and is encouraging investors boost their allocation to raw materials. Part of the argument is that most investors are underweight commodities as an asset class and many have no exposure at all. That leaves room for increasing buying power, in their opinion. at a time when Russian gas and grains are being shunned by Western countries. Furthermore, Ukraine agriculture exports are expected to be badly crimped due to the war.

Goldman Sachs Group Inc. is also bullish on raw materials, in part on their role as an inflation hedge. Goldman warned in an early April note that a global copper shock was under way. On a secular basis, the shift from combustion engine cars to electric vehicles (EV’s) means increasing demand for the metal.

While previous energy spikes have had relatively short durations, this one could last longer. That’s because Europe relies heavily on Russian natural gas. As Putin continues his murderous assault on a sovereign European nation, finding ways to replace this supply could take years.

For its part, the US has promised an extra 15 billion cubic meters of liquefied natural gas in 2022. However, that amount is only around ten per cent of what the EU currently buys from Russia. If Europe holds to its commitment of reducing gas imports by two-thirds, that likely means an extended period of elevated energy prices.

One way to participate in rising commodity prices is through companies which extract and sell raw materials. Energy exploration and production (E&P) companies have been gaining relative strength this year and the trend may continue if prices stay firm and government eases regulations which have restrained drilling.

In the agricultural products, farm equipment makers such as Deere and Agco Corp, should continue to see higher sales volumes from farmers flush with cash from higher grain prices.

High-dividend paying stocks is another sector quietly gaining momentum. Our readers know we have favoured this space for some time and have strategies built around the concept. The Dow Jones Dividend Select Index is up 5.9% this year and has outperformed the S&P 500 by over 13% year-to-date.

Bryan Dooley, CFA is the Chief Investment Officer at LOM Asset Management Limited in Bermuda. Please contact LOM at 441-292-5000 for further information. This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.

Goldman Sachs Group Inc.: bullish on raw materials, in part on their role as an inflation hedge.

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Published April 19, 2022 at 7:57 am (Updated April 19, 2022 at 7:46 am)

How investors can protect against inflation

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