Ten Investments to Hedge Inflation
A man, cautious by nature, enters a bar. After surveying the available stools, he selects one near the front door, far from the cash register. His logic is this: In the event of a hold-up his distance from the register minimizes the risk of being hit by a stray bullet. In the event of a fire, his proximity to the door allows for a speedy departure. No sooner does he sit down--rather pleased with his analytical prowess--than the ceiling fan above the stool falls, killing him instantly. The moral of the story (besides the fact it was a Tuesday night and he had no business drinking) is that there is no panacea and no perfect stool. Sadly this applies for happy hour too.
The same can be said for investing. Avoid one-legged prognostications, especially during periods of political and economic turmoil. Sometimes this wisdom is forgotten as is often the case in the raging inflation-vs-deflation debate. No macroeconomic force rules with impunity. Indeed the real question may be this: what if this Clash of the Inflation-Deflation Titans (so favored by our headline-driven press not to mention our NFL ‘us-versus-them’ frame) is conceptually flawed? What if deflation and inflation enjoy a subtle alliance with one another? What if (gulp) there is no correct jersey to wear and we must navigate two opposing forces simultaneously?
Paradoxical though it may seem, in an entity so vast and complex as the American economy, the forces of deflation and inflation are at work simultaneously, working their push-me-pull-me gyrations in varying degree, across various sectors. There’s even a term for this two-headed monster: biflation. Let’s follow the bouncing ball. First of all, biflation requires a wall of money which the Fed via QE2 is providing. It’s what this money favors that creates the bifurcating effect. High-end, debt-dependent assets are avoided in favor of low-end commodity-based assets. Another way to say this is that inflation shows up where demand allows it--the proverbial path of least resistance—which is not luxury yachts and large houses but essential assets that are widely available and non-substitutable: energy and food come quickly to mind. The effect is housing prices go down and cotton prices go up. But it’s not simply that one asset class goes up while the other goes down; it’s that one goes up in part because the other goes down as money tumbles down the necessity curve from luxury yachts into fuel prices. In this way, one sector’s deflation feeds another’s inflation.
Now if you insist on taking a snapshot in time, then yes, this biflationary process might oblige by posing for a picture. But the important point is that we’re always talking about predominant and dynamic forces, not monolithic or static ones. Even this Fed-driven biflation can be taken out by a ceiling fan or two. Here’s one. In the event of a European Monetary Union (EMU) defection, the departing nation’s home-currency would immediately suffer an explosive inflationary surge, precipitating a massive flight to safety into US bonds and a resultant collapse in US interest rates. This would be a deflationary event of significant proportions. Then there’s the huge underutilized manufacturing capacity all around the world which in a continued low-growth environment would only compound the deflationary overhang. Oh and what about a China collapse?
Because we are attempting to make investment decisions now, we must do our best to interpolate the future from our current blurry snapshots. The recent spate of headlines has tended to favor the inflationists’ worldview. Commodities prices are up significantly in the past year; Cotton 80.5%, Sugar 42.1%. The dollar has fallen sharply in the last year due in large part to the Central Bank’s quantitative easing policy.
Think of this large vat of money supply as latent inflation or inflation-in-waiting. Once this money manifests through lending activity and acquires some velocity (the official microeconomic term is ‘buying stuff’), price levels will respond in an upward fashion. Even more important, the Fed is signaling with QE2 that it fully intends to encourage inflation, that it fears deflation, and that it will go to extreme measures to prevent deflation. Using our biflationary worldview, the Fed is using inflation to fight deflation. That the Fed is an active booster for inflation is enough to favor an inflationary thesis all by itself.
So far we’ve discussed biflationary effects and feedback loops. What about good old-fashioned economic activity, you know, breaking a sweat to fashion a widget or two? Absent the exchange of goods and services there would be no price level fluctuations and we could solve the whole inflation-deflation bugaboo straightaway. But seeing as we all have an eye on some doggie in the window, what if during a period of predominant price level increases, economic growth is slow to flat? This would be a stagflation scenario, that is, high inflation coupled with low growth making for a worst-of-all-worlds scenario. This is about where I am in my own thinking. No sooner do you bring home your wage-stagnated paycheck than it evaporates, and even faster than the one last month.
The problem with stagflation is that there really are no good investments. Low growth does not make for mouth-watering stock market returns while inflation erodes existing wealth. So an inflation hedge strategy probably serves as a decent stagflation defense too. From a stock-picking standpoint, investors may want to focus on companies that have the ability to absorb price increases within their own pricing structures and ‘pass the inflation along’ to some hapless bag-holder further down the line. This ability, often called pricing power, is driven in many instances by the criticality of the product at-hand. It can also result when a company’s product is the only game in town and/or product substitution is hard. A captive audience is inflation’s best customer.
My top-10 list includes some such companies. You’ll notice some of the usual suspects on my inflation hedge list too. These are offered in no particular order.