Head of Fixed Income Strategy
Summary: The market is desperately denying that inflation is rising, even when people are paying more for necessary goods amid the pandemic. Before it's too late, it is crucial to identify instruments that can hedge investment and savings against inflation. Compared to gold, we favour Treasury Inflation-Protected Securities (TIPS) as they provide a stable cash flow which can be reinvested in new arising opportunities. They are also an excellent diversification tool as they do not correlate with fixed income and equity products.
In life and the financial market, it is true that by not deciding to move in any direction, you are actually making a choice. This is especially true today as optimism fuels an overleveraged stock market; but, deep down, everybody knows that there are incredibly significant economic problems. Investors buying into overpriced stocks and pushing prices even higher insist on seeing a glass very much full. They desperately try to ignore that a drop of too much water will have the glass spilling all over.
This is very much what is happening with inflation. There are clear elements today that are telling us that inflation will eventually rise. However, because the human brain has removed from its memory periods of high inflationary pressures, investors still flock the equity market and risky credits. People believe that central banks worldwide will be in their perpetual rescue. Well, the market today is a clear example of central banks failures. Desperate monetary policies have not been able to ignite inflation and prevent financial crises. Therefore, central banks will also most likely be powerless to save investors from overshooting inflation.
Inflation is rising, and the market knowingly ignores it.
It is crucial to understand that we are already living in an inflationary environment; however, the CPI index is failing to reflect changes in prices. The CPI index is a quite controversial measure for inflation because it compares the price of a fixed basket of goods and services spanning two different periods. This basket is decided by somebody that states we need certain goods and services over others to maintain a constant standard of living. The reality is that this basket can be different for any one of us because we give value to objects and services differently.
The Covid-19 pandemic has set in motion a sequence of events that are already exacerbating inflation as the stuff we need today is more expensive. I have analyzed data coming from the U.S. Bureau of Labor Statistics and the picture that comes out from them, it's clear. The pandemic has caused a price surge for those items that we actively need, while it provoked a price drop for those items we do not need any longer.
For example, the food at home has become more expensive together with housekeeping supplies and medical care. Travelling, women clothes and public transportation have considerably fallen in price.
Treasury Inflation-Linked Securities are designed to protect against inflation.
As inflation pressures continue to rise, it is essential to understand how to protect our investments and savings against it.
Many set their heart on gold; however, it is not an isolated inflation play. The precious metal is sensitive to the price of the U.S. Dollar, it is often used as a geopolitical instrument, and it is sensitive to risk appetite. Research shows that investors tend to buy gold when it is at a near peak exposing holders of the precious metal to more downside than upside.
TIPS, on the contrary, are an isolated inflation play, which also provides a steady cash flow over time as inflation rises. To give you an example, if investors were putting $10,000 in 30-year inflation linkers paying a coupon of 10.45% in 1982, by 2012 they would have pocketed around $35,000 in cash flow. At maturity, the holders of TIPS would have also gotten the principal adjusted by inflation. If an investor were putting $10,000 in gold in 1982, by selling it in 2012, he would have made approximately the same money. The big difference is that he would not have received any cashflow payment during the past 30 years. Therefore, that money was tight in that one position, which otherwise could have been put at work in other investment opportunities.
Although TIPS are now expensive compared to the '80s, it is possible to say that there is plenty of appreciation opportunity ahead.
Firstly, the Federal Reserve has been increasing its ownership of the TIPS market since the beginning of the year. Many argue that the FED is trying to push TIPS prices higher to have the market believing that inflation is indeed about to come. As a consequence, TIPS prices are at record high levels, offering negative yields across the yield curve.
Secondly, the Treasury has been issuing increasingly fewer TIPS in the market.
Therefore, while the upside to hold these securities until maturity vanishes as the coupon that they pay is very low, price appreciation potential continues to be massive.
Given the low supply of Treasury Inflation-Protected Securities in the primary market, as soon as inflation expectation rise, we can expect demand to increase fast pushing TIPS further up.
Real assets, commodities and TIPS are investors' best bets in an inflationary environment.
Treasury Inflation-Protected Securities and gold are not the only assets that can give you protection as inflation rises.
During periods of high inflationary pressure, real estate assets rise in value as rents soar and demand to purchase a property increases. Several ETFs track the prices of these assets; however, the table below, we have highlighted the iShare Core US REIT, which gives exposure to the U.S. real estate market.
The stock market will be volatile as inflation rises, and CAPEX will most likely grow faster than revenues. However, growth stocks can have a nice upside in such an environment. Similarly, U.S. Large-caps Stocks will be able to mitigate better a blow coming from inflation compared to mid-cap companies. In an inflationary context, we dislike developed foreign stocks and emerging market stocks.
Within the fixed income market, whatever provides a low yield will fall in value fast, this is why we dislike investment-grade bonds and sovereigns. TIPS and high yield bonds will be the only fixed income securities to be able to provide a cushion against inflation.
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