Notes on Inflation

I was going to write a post about inflation right after I started at Composer, but I thought, “Nah, it’s going to fade after all these supply chain issues get sorted and Omicron goes away”. And then, I was going to write about it when it hit 7% in January, but I got distracted by Risk Parity. So, here we are…

I can’t ignore it anymore. 

Ugh. I am the Fed.

‍Inflation, measured by the Consumer Price Index, hit nearly 8% for February, a four-decade high. Somewhat concerning is that household’s expectation of future inflation also increased. This is worrying because the Fed is able to control inflation, in part, because people believe the Fed can control inflation. If people believe prices will continue to go up in the future, they may push for a raise now. Similarly, if companies expect input prices to increase in the future they may continue raising their prices today. 

From the CEO of ACCO Brands on price increases:

“We didn’t fully recover last year from inflationary cost increases. So the plan is to continue to raise our prices until we recover.”

Expectations of higher future inflation may make it more difficult for the Fed to engineer a soft landing with interest rate hikes. However, the Fed started the process yesterday with a 25 basis point increase in the target federal funds rate and signaled an aggressive 6 more rate increases this year.

The path we took to get to this point is understandable, if not ridiculous when you write it all down. A global pandemic ripped through supply chains causing disruptions and shortages on everything from computer chips to toilet paper. Every time we thought the pandemic was easing a new variant emerged to disrupt everything all over again. 

In addition, there’s not enough houses, and no one can build more because of all the supply disruptions. As a result, people are offering way above asking price, bringing suitcases full of cash, and waiving inspections to buy homes. And then, after all that(!), Russia invaded Ukraine sending commodities like wheat, metals, and oil, into a frenzy. 

Inflation is eating the world

The problem is that inflation eats into returns. If my portfolio returns 5%, but everything I need to buy is 7% more expensive, then I am 2% poorer. This is why you often hear investors talk about real returns. 

Portfolio return - inflation = real return

So what’s an investor to do? Unfortunately, there is no perfect hedge for inflation.

Stocks could be a good long-term hedge against inflation because average equity returns tend to be above inflation. But, the key word in that sentence is average. Short-term inflation spikes can be painful because they often coincide with poor equity market performance.

Further, the usual suspects, TIPs, Bitcoin, and Gold have not performed particularly well during this recent bout of unexpected inflation. 

Vanguard research points to commodities as the best hedge against unexpected price increases: 

“Over the last three decades, commodities have had a statistically significant and largely consistent positive inflation beta, or predicted reaction to a unit of inflation. The research, led by Sue Wang, Ph.D., an assistant portfolio manager in Vanguard Quantitative Equity Group, found that over the last decade, commodities' inflation beta has fluctuated largely between 7 and 9. This suggests that a 1% rise in unexpected inflation would produce a 7% to 9% rise in commodities.”

And, it’s not just researchers that have homed in on commodities. Reddit has hosted some heated debates on the topic, as well. A poor old investor asks if he or she is too late to the party. Yeah, probably. But, what do I know?

In the current environment, it is impossible to strip out the effects of geopolitical events on the price of commodities, but they have performed exceptionally well in 2022. The chart below shows the one-year performance of the aforementioned DBC, a popular commodities ETF, and SPY, an S&P 500 ETF.

However, it is important for investors to realize that holding commodities comes at a cost. First, commodity ETFs may require a K-1, which is an IRS tax form required for partnership income. In addition, these ETFs may have higher than average fees and regularly distribute dividends. Always read the prospectus!

Second, and probably most importantly for investors, commodities can have low returns for long periods of time. Look at DBC, since inception. The S&P is up over 350% and DBC returned 17%. And, if you looked at DBC from inception through the end of 2021, returns were negative.

That is some costly inflation insurance. 

The takeaway? A phrase we throw around a lot at Composer is, “nothing works in all market environments”. [1] The same is true for fighting inflation. It’s important for investors to think about diversification in light of the different factors that can impact a portfolio (e.g., inflation, interest rates, economic growth). And secondly, if you plan to add commodities to your portfolio, make sure you have the right expectations for future returns.