Hedging Inflation with Real Assets

gold? Bitcoin? real estate? stocks? inflation-indexed bonds?

I’m a permabear when it comes to inflation. I will never be surprised by inflation taking off. I will be surprised if it doesn’t.

My view is that with the national debt and stock valuations soaring, the public is accumulating tons of paper wealth. I have no faith in the Fed to overcome the inflationary implications of that. The Fed’s ultimate job is to make sure that the government can fund itself, and when push comes to shove it will not be able to abandon that job in order to fight inflation.

You can disagree with me on that. If you don’t worry about inflation, then the rest of this essay will be irrelevant to you. I am not here to argue about that. Instead, I want to ruminate about what to do about one’s portfolio to protect against an outbreak of inflation, assuming that it is a risk.

A Handy Formula

I teach that the profitability of an asset is equal to its rental rate plus its appreciation rate minus the interest rate.

For example, suppose you invest $400,000 in an apartment on which you can collect $20,000 a year in rent. Then the rental rate is 5 percent. If the rent and the market price of the apartment each go up at 2 percent per year, then the appreciation rate is 2 percent. And if the interest rate that you pay to finance the property (or the opportunity cost that you give up by not earning interest on money you have tied up in the property) is 6 percent, then that is the interest rate in my basic formula.

In this example, the profitability = 5 + 2 - 6 = 1 percent. The apartment is a good investment, because profitability is greater than zero.

I am leaving out some other factors here. There is maintenance. There are taxes. There may be condo fees (HOA fees). There is insurance. There are uninsurable risks of various sorts. I am also leaving out the fact that many of the expenses, including interest, are tax deductible.

Appreciation is the key variable

The main implication that I draw from this formula is that appreciation is the key variable. The other factors—the rental rate, the interest rate, and “other”—are pretty much set. But appreciation could turn out to be much higher or much lower than what you anticipate.

An asset is a hedge against inflation if and only if it can be relied on to appreciate more if inflation takes off. So-called “real” assets are supposed to do that. These include gold (or commodities in general), stocks, Bitcoin, real estate, and inflation-indexed bonds (TIPs).

I will say right off the bat that I like i-bonds. Those are inflation-indexed bonds that carry a set interest rate above the rate of inflation, with taxes on the income deferred until you cash in the bond. One catch is that regulations limit you to buying $10,000 per year per person. The only other potential problem that I can see is that the official measure of inflation may not move by as much as your personal cost of living, in which case for you the purchasing power of these bonds could decline. I think that this is a relatively minor risk compared with the risk in other inflation hedges.

I also can say right off the bat that I do not like Bitcoin. With Bitcoin there is no return, and hence in my handy formula its “rental rate” is 0. You may make a lot of money speculating in Bitcoin, but I predict it won’t be because of inflation.

When the real interest rate rises

When inflation rises, interest rates tend to rise. In fact, the interest rate often has to rise by more than the inflation rate in order to bring inflation under control. The financial markets will determine the amount of the interest rate increase, with the Fed having to go along (while pretending to lead).

When the interest rate rises by more than the inflation rate, this is known as an increase in the “real” rate of interest. When inflation is 2 percent and the interest rate is 3 percent, the real rate is 3-2 = 1 percent. If inflation goes to 8 and the interest rate goes to 12, the real rate goes to 12-8 = 4 percent.

When the real interest rate increases, this puts downward pressure on the values of real assets. That includes all of our potential inflation hedges.

For housing, even if the real interest rate does not rise, the higher interest rate causes an affordability problem. In my profitability formula, an interest rate of 10 percent and an appreciation rate of 6 percent works out the same as an interest rate of 6 percent and an appreciation rate of 2 percent. But with a thirty-year fixed-rate amortizing mortgage the monthly payment tells a very different story. On a $400,000 loan, the monthly payment jumps from $2500 to $3500 with the 10 percent mortgage. The apartment is still profitable to buy, but only if you can find the wherewithal to make the payments early on (in later years, inflation will make the monthly payments seem tiny).

The bottom line is that if you invest in housing and inflation takes off, you are likely to find that buyers cannot afford to buy your property. If you are forced to sell soon, you could find that your house has depreciated, meaning it is not a hedge at all.

Gold is like Bitcoin in that its price moves sharply with sentiment, and it earns no rent. So it is not my choice for a hedge.

I found out in the recent inflation surge that inflation-indexed bonds performed poorly. Think of TIPs as “real” bonds, earning a “real” interest rate, which is the rate they pay before an inflation add-on. As I pointed out above, the real interest rate often rises when inflation rises. If I bought TIPs when the real interest rate was less than 1 percent, and then the real interest rate goes to 2 percent, I can suffer a severe capital loss. I have to offer my lousy 1 percent real bond at a steep discount to get somebody to take it off my hands.

Finally, we have stocks. When I was growing up, the conventional wisdom was that stocks were a hedge against inflation. Then came the 1970s. Inflation soared, and stock prices…went way down. Why this happened remains controversial. I think it may have been due in part to a rise in the real interest rate. Nobel Laureate Franco Modigliani attributed it to investor irrationality. If investors are subject to swings in sentiment, then you cannot count on stocks as a hedge.

During the recent inflation run-up, commodity funds performed well. I prefer a commodity fund to investing in gold, which is a single commodity. Because of human ingenuity in creating more economic value using fewer resources, there has been a gradual secular decline in the prices of commodities relative to other goods and services. Should this continue, and should inflation not pick up, commodities will underperform as an investment. But I value them as an inflation hedge.

As an inflation permabear, I top out on i-Bonds, allocate some money to TIPs, and buy some commodity funds. Do not ask me for any more specific investment advice. I am not considered qualified to be an investment adviser, and if you had stuck with me the past 10 years you would have underperformed all of your friends who went heavily into stocks and/or Bitcoin.