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The New Inflation Playbook: How Investors Should Protect Themselves

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This morning, data from the U.S. Labor Department showed that the Consumer Prices Index (CPI) jumped by 5% last month, the largest gain since August of 2008. There has been a lot of talk over the last couple of years as to when inflation would come, but these data suggests that it is here now, so how should investors react?

If you go back a few decades, protecting against inflation was an important part of portfolio construction for any investor. Boom and bust cycles were considered the normal state of affairs, and investors were all too aware of the negative impact that rising prices had on real returns. After an extended period when the Fed and other central banks around the world have been troubled by inflation that they consider too low, there is no well-known, established playbook for investing in a rising price environment but, even if there were, the circumstances now differ from those in the 1970s, so protection measures are different too.

For starters, several of the things that would now be considered options to protect against inflation didn’t exist back then and investor access to even those that did was severely limited.

From an economic perspective, it can be argued that rising consumer prices are not the definition of inflation, but a symptom of the real problem. Those price rises happen because the real value of the dollar is falling, even though the real value of the things purchased hasn’t changed. Purchases are exchanges and two things factor into price: the value of the thing bought, and the value of the thing exchanged for it. In America, that is typically U.S. dollars. If it takes more dollars to buy something than it did before, it stands to reason that the shift is in the relative value that people place not just on the object purchased, but also the currency used to make the purchase.

If that is true, then the best hedge against inflation is to buy another currency, one where its purchasing power will remain the same or even increase as the dollar loses ground. In the past, the classic way of doing that was to invest in gold. Now, there are alternatives such as cryptocurrencies, most notably bitcoin. One of the advantages of bitcoin is that supply is inherently limited, so its price and value in dollar terms is pre-programmed to go up.

Regular readers will know that I have been a supporter of bitcoin for a long time, in part because it does offer protection against the corrosive effects of QE and massive expansion of the federal debt. However, it wouldn’t be my choice at these levels as an inflation hedge.

There has been so much speculation in crypto over the last couple of years that its role as a store of value is much more than priced in at this point. Put simply, any asset that is standing more than 250% above its level of a year ago has a lot of price rises factored in. Clearly other things are driving pricing, and that means that even if CPI increases continue and the dollar does lose value, there is no guarantee that bitcoin will be a beneficiary. In fact, the economic weakness and monetary and fiscal tightening that would result will mean less capital chasing assets, and that could lead to an adjustment that would negatively impact assets such as bitcoin.

So, as much as I support bitcoin in a general sense, I would look elsewhere for inflation protection right now.

That doesn’t mean, however, that I would prefer gold, commodities, or real estate, which are the traditional inflation hedges in this situation. The problem is that the system has been so awash with cash that money managers have been able to bid up those kinds of assets in advance of inflation while still putting huge amounts into both stocks and bonds. Inflation in the price of consumer goods may be coming, but asset inflation in advance of it has been around for years.

In those circumstances, inflation protection is not so much about finding assets that will actually gain from rising prices or a falling dollar as it is about finding things that won’t lose value. That is why stock in companies that can pass on rising prices quickly to their customers, such as those in the consumer staples sector, would be a better option, as would another thing that wasn’t available in the 1970s and 80s: Treasury Inflation Protected Securities (TIPS).

TIPS are Treasury bonds that protect the principle of an investment by increasing their face value in line with CPI and were launched in 1997. They are an extremely conservative investment option, with an accent on return of principle, rather than return on principle, but that is kind of the point here. Prices are rising, and the price of most hedges have already soared, so there is too much risk there for them to be a real hedge.

This is not your grandpa’s inflation, so you can’t turn to your grandpa’s inflation protection playbook. At current levels, things like gold, other commodities and real estate don’t offer a reduction in risk, so, if you are worried and want to make changes you have to go extremely conservative and into things like consumer staples and TIPS. That may negatively impact your returns for a while, but it an insurance policy that is worth considering.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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Martin Tillier

Martin Tillier spent years working in the Foreign Exchange market, which required an in-depth understanding of both the world’s markets and psychology and techniques of traders. In 2002, Martin left the markets, moved to the U.S., and opened a successful wine store, but the lure of the financial world proved too strong, leading Martin to join a major firm as financial advisor.

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