Inflation is low now, but it may not stay that way.
The Federal Reserve announced in late August that it has new guidelines to monitor inflation and employment. The central bank will allow slightly higher inflation levels over the short term following periods when inflation levels were less than 2% — its longtime inflation target. Under the new policy, the Fed may now allow inflation levels to range between an annual rate of 2.25% and 2.5% before it will consider raising interest rates to tame inflation. Given this change of tactics, investments that benefit from higher inflation may find underlying support from this structural shift. Here are six inflation-protection investments to consider under these changing conditions.
Treasury Inflation-Protected Securities
Inflation doesn’t have to be rising sharply like it was in the late 1970s and early 1980s to eat away at people’s earning potential, says Mark Carlson, senior investment strategist at FlexShares ETFs. Starting with $100, even with a low inflation rate of 2%, compounded over 10 years, investors are left with approximately $78 of their purchasing value. To mitigate the inflation risk on what’s considered a risk-free asset, the federal government created Treasury Inflation-Protected Securities, or TIPS. TIPS are Treasury notes and bonds with an inflation component, Carlson says. TIPS exchange-traded funds — such as the SPDR Portfolio TIPS ETF (ticker: SPIP) — come in various maturities. These include short-term funds, covering just a few months, to long-term funds, stretching out several years.
Equities are valued based on a company’s revenue, earnings and cash-flow growth, Carlson says. According to him, companies whose business models may be linked to sectors of the economy that benefit from inflation or are the source of inflation in the macro economy tend to fare better than those with the exact opposite type of business structure. “Equities in themselves tend to have a little bit better of a correlation to inflation than, say, fixed-income investments,” Carlson adds. Among the companies that benefit from higher inflation are those in the materials, industrial and transportation sectors, since they are able to pass along higher prices. For example, the materials sector — which includes paint manufacturers and chemical companies — already looks poised to perform well through the rest of the year in a post-pandemic environment.
When market strategists think about how economies come out of sharp recessions and how demand rebounds after very low periods of inflation, they look back to see what asset classes have traditionally benefited from inflation. “Commodities, broadly speaking, tend to benefit,” says Bill Northey, senior investment director, U.S. Bank Wealth Management. “A lot of that is coming out of a weaker economic environment into one that is stronger, where you have rising demand, and the supplies perhaps don’t catch up as much.” Commodities such as industrial metals, energy and food commodities traditionally benefit from higher inflation. A good example of a broad-based commodity ETF is the iShares S&P GSCI Commodity-Indexed Trust (GSG), which holds futures contracts based on the S&P GSCI Total Return Index.
Some assets do well when inflation is anticipated — and their value can start rising before inflation takes off. Gold prices have been rising on higher inflation expectations, similar to how it behaved after the 2008 financial crisis, says Kristina Hooper, chief global market strategist at Invesco. Gold is seen as a store of value during inflationary times because of the potential for rising prices. “Even though inflation didn’t come to fruition (in 2008), it remains a concern of investors,” she says. “I think that will also drive a cohort of investors into gold shares.” Hooper adds that the Fed’s new inflation target policy also benefits gold because the central bank is becoming more tolerant of higher inflation. Investors can buy gold coins or bars, physically backed gold ETFs — like the Aberdeen Standard Physical Gold Shares ETF (SGOL) — or gold-mining equity ETFs such as the VanEck Vectors Gold Miners ETF (GDX).
James West, CEO of Principal Street Partners, says there are two types of asset classes that do well in inflationary times. “Anything where either the replacement costs are very sensitive to increases in inflation, or you have contractual provisions in the cash flows of those assets that go up,” he says. Historically, real estate fits into that category because rents can rise and the value of the real estate itself can go up. Further, the forecast for future cash flow can rise. Investors who can buy individual pieces of real estate benefit the most, although some publicly traded real estate investment trusts, or REITs, can rally — especially if the REIT is in a sector of the economy that is doing well.
Most direct investments in infrastructure assets are done through a financial advisor — and they tend to be long-living investments of 10 years or more. Most of that investing is done in traditional infrastructure assets such as toll roads and ports. However, West says, investors should think of modern economy infrastructure assets such as data centers, cell towers and even some renewable energy infrastructure. He says not only can investors benefit from inflation and cash flow, but there’s also the potential for growth with the rollout of 5G, or fifth generation technology, and greater adoption of the internet of things, such as through smart home devices. The Global X Internet of Things ETF (SNSR) is one of several ETFs on this theme.
Six inflation investments to consider:
— Treasury Inflation-Protected Securities.
— Real estate.
— Infrastructure assets.
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