Inflation was once the scourge of the global economy and the enemy of politicians.
Recently, inflation has become one of the government’s most highly valued tools.
Federal debts have ballooned to record levels relative to GDP as governments gouged on record deficit spending to assist their economies in surviving the COVID-19 pandemic.
Record Money Printing
Deficits came in the form of money-printing, which was distributed to individuals, small businesses and multinational corporations alike. These subsidies were necessary to stave off economic collapse as the pandemic drove global commerce to a halt.
Starting in early 2020, governments unleashed a massive flood stimulus, leading to extraordinary growth in the outstanding supply of money, as shown below.
As vaccine uptake has spread throughout the world and countries begin to move past the devastation caused by Covid, a new economic order remains. In many cases, governments now have debt burdens that are too large to be supported by economic activity alone.
Once debt loads become unbearable, inflation, or the reduction in the purchasing power of money, is seemingly the only way out.
Fiscal spending in response to the pandemic has exceeded $5 trillion. The M2 money supply has seen a 26% year-over-year surge, the largest gain since 1943. The M1 money supply is up by a shocking 316%. No wonder used car prices are rising at a double-digit clip.
Meanwhile, the Federal Reserve has shown no indication of slowing its quantitative easing, maintaining its $120 billion in monthly purchases of Treasuries and mortgage-backed securities that it began in response to the pandemic, even as cases of Covid decline markedly.
Consumers are seeing their bills increase and are becoming concerned. Food prices are up, gas prices are up, and home prices are up. Many staple goods have increased in price by double-digits. The only thing rising at a faster clip are consumers’ Google searches regarding inflation.
Inflation is top of mind for investors as well, as inflation expectations recently hit 15-year highs.
Unsurprisingly, headline inflation is now manifesting itself through the CPI. Aside from anecdotal evidence, investors now have confirmation that inflation has reared its ugly head. The only debate is whether inflation is transitory, as the Federal Reserve wants you to believe.
With unsustainable levels of government debt, burdened in response to the global pandemic, the scenario in which inflation is not transitory should be prepared for as a reasonable probability.
To prepare for higher inflation, investors should consider incorporating two inflation-fighting measures in their portfolio: Protecting purchasing power and generating income.
Protecting Purchasing Power
In an inflationary environment, investors’ number one concern will be maintaining purchasing power or protecting against the rapid decline in the value of money. It does not take much of an increase in the CPI to have consumers begin having nightmares of wheelbarrows full of cash.
There are two key tools that investors have to maintain purchasing power:
Bitcoin and gold both act as a store of value, given their scarcity. They are true alternative assets, as both have exhibited a low correlation to traditional asset classes.
For some odd reason, there is a warring debate between bitcoin maximalists and gold bugs. It does not have to be either gold or bitcoin. It can be gold and bitcoin. Both assets provide the benefit of protecting an investor’s portfolio from currency depreciation over the long-term.
However, both can be volatile and have long stretches of underperformance. Nonetheless, the goal is to diversify and prepare for an inflationary environment, therefore having small allocations to both bitcoin and gold help reduce risk within a portfolio.
In addition to alternative currencies, such as gold and bitcoin, there are two additional assets that can help maintain purchasing power:
- Real estate
These so-called “real assets” tend to increase in value as fiat currencies depreciate, given their income generating potential.
How to play it?
All “four horsemen of the inflation apocalypse”, being bitcoin, gold, real estate and infrastructure, are core holdings in the Accelerate OneChoice Alternative Portfolio ETF (TSX: ONEC).
Many investors have an income requirement for at least a portion of their investment portfolio. Given the fixed nature of fixed income, inflation is not kind to bonds and therefore income-seeking investors should be looking elsewhere.
Specifically, fixed income investors need to forget about the “fixed” part.
Floating rate yields are the place to be with the current market conditions, given their ability to generate a higher yield in an inflationary environment.
As interest rates climb, traditional fixed income portfolios will be punished. Bonds are already in a bear market, as the 10-year yield has climbed from 0.5% to 1.6%. The Treasury bond ETF is down more than -20% from its high last fall.
Source: Google Finance
What do you think will happen to supposedly safe bonds if the 10-year Treasury yield exceeds 3.0%?
As yields rise, floating rate strategies can participate in the uptick in rates by offering a variable yield to compensate investors.
How to play it?
Floating rate bank loans:
The SPDR® Blackstone Senior Loan ETF (NYSE: SRLN) invests in a diversified portfolio of first lien senior secured floating rate bank loans. The current weighted average yield is 4.6%.
Rate reset preferred shares:
The BMO Laddered Preferred Share Index ETF (TSX: ZPR) invests in a diversified portfolio of rate reset preferred shares. The current weighted average coupon is 4.4%.
Merger arbitrage and SPAC arbitrage:
While fixed income yields hover near all-time lows, arbitrage yields remain wide, sitting at or above their recent averages.
Arbitrage is a strategy that offers a floating rate yield exposure that is generally uncorrelated with traditional asset classes. By combining SPAC and merger arbitrage, an investor can expect to earn higher returns than senior loans or preferred shares.
The Accelerate Arbitrage Fund ETF (TSX: ARB) invests in a diversified portfolio of SPAC and merger arbitrage opportunities.
Prepare for the Battle Against Inflation
Inflation is the most significant risk facing investors today.
There are many reasons why investors should be concerned about recent market developments. Protecting wealth is the number one reason.
Thankfully, investors have access to a handful of useful tools to maintain purchasing power as the dollar depreciates and generate income as interest rates rise.
Interested in hearing more?
I discuss the tools that investors have to protect their investment portfolios against the scourge of inflation on Thursday’s webinar. Register here: