Until 2021, inflation was really only a minor concern for American investors for several decades. The inflationary surge that began in the first half of 2021 was unlike anything investors had witnessed in approximately forty years.

The Consumer Price Index (CPI) touched 9% in June 2022, which was a level not seen since 1981, Ronald Reagan’s first year in office. While year over year inflation rates have since retreated from their mid-2022 peak, debate rages over where we are headed from here.

It is conceivable that we might go back to inflation rates that are at or below the Federal Reserve’s target of 2% for the PCE Index, which it formally adopted in 2012. (Average monthly CPI was 2.85% from 1983 through 2023). If this optimistic scenario were to play out, it would likely be because Covid-related supply chain disruptions, as well as other economic frictions related to the rapid closing and reopening of the global economy, produced short-term inefficiencies that just needed some time to work out.

Perhaps this most recent bout of inflation will indeed turn out to be “transitory” as Treasury Secretary Janet Yellen initially advised us—a one-time problem caused by an unusual event, even if it takes quite a bit longer to sort out than she first anticipated.

A less optimistic interpretation is that the current inflation problem is rooted in monetary and fiscal policy, rather than short-term structural frictions or the post-Ukraine spike in oil and gas prices.  This would suggest we may be facing a more stubborn problem and that the “old normal” will not necessarily return.

Those who agree with Milton Friedman’s famous assertion that “inflation is always and everywhere a monetary phenomenon” emphasize the vast scale of monetary expansion that has taken place over the supply chain story. The risk is that we have simply printed a lot of money and, in doing so, let the inflation genie out of the bottle.

Towards the end of 2023 and as 2024 begins, the market is clearly not pricing in this more pessimistic interpretation. The market seems to have confidence that the Fed’s restrictive policy will do the trick. Both bonds and stocks have rallied as long-term inflation expectations have come down considerably.  

Current market optimism is reflected in an important indicator of inflation expectations, what is known as the “5-year, 5-year forward inflation expectation rate” (which represents an average of what inflation is anticipated to be for the five-year period beginning in five years). This metric is inferred from the pricing of Treasury Inflation-Protected Securities (TIPS) relative to standard Treasuries.

What is particularly interesting about the “5-year, 5-year” is how stable it has actually been throughout this recent inflation ordeal. The Federal Reserve continues to maintain a policy inflation rate target of 2%. Pre-Covid, bond investors were pricing future inflation rates at around this level.

Inflation expectations then fell sharply during Covid and the related market crash and briefly pierced 1%. By the end of 2020, however, we were back around 2%. And even as CPI nearly reached double digits in 2022, long-term inflation expectations never really got much higher than 2.5%. The 5-year, 5-year closed 2023 at 2.2%.  

Notwithstanding the market’s recent confidence, inflation is one of the least understood subjects in investing and economics. Conventional wisdom holds that central bank interest rate manipulation is the key. If the Fed tightens, demand is destroyed, sending price levels down. If the Fed eases, demand is stimulated, sending price levels up.

There is an intriguing counternarrative that suggests the mathematical relationship between interest rates and inflation described above not only does not hold but works in the exact opposite manner. This theory is known as Neo-Fisherianism. We have written about Neo-Fisherianism in the past and may return to the topic. Curious readers may find it worth investigating on their own. One of our priorities at 76research is to explore alternative viewpoints that have real empirical support but are typically ignored by mainstream financial sources.

While the true causes of this most recent inflation flare-up remain up for debate, the answers to these questions may not even matter.  Changes of a technological, social and political nature are underway that could drastically change the inflation playbook anyway.

A new paradigm of inflation risk?

Consider, for example, recent discussions of “Modern Monetary Theory,” or MMT.  The Australian economist Bill Mitchell is credited with coining the phrase in 2008, as the global financial crisis sparked an unprecedented wave of monetary expansion via quantitative easing.

At the risk of oversimplification, the central premise of MMT is that sovereign nations operating with their own fiat currencies can directly fund government expenditures by printing the necessary funds. (Fiat currencies such as the U.S. dollar or the Euro are linked neither to commodities like gold nor other currencies.) Taxation can then be used, so the theory goes, as a tool to control inflation in the event such unrestricted money printing becomes a problem.

Under an MMT regime, the government does not have to bargain with taxpayers through the democratic political process to fund its operations but rather can just tell the central bank to cover its costs directly. Unsurprisingly, American politicians who favor a substantial expansion of the federal government (and are not terribly concerned about the opinions of taxpaying citizens on this topic) have warmed up to this novel framework. Congresswoman Alexandria Ocasio-Cortez has stated that MMT should become “a larger part of our conversation.”

I think the first thing that we need to do is kind of break the mistaken idea that taxes pay for a hundred percent of government expenditure. - Rep. Alexandria Ocasio-Cortez

With politicians around the world promoting the idea that trillions of dollars of investments are necessary to address the existential risk of climate change, there is a natural interest in restructuring government financing in a way that bypasses taxation as the primary funding mechanism.

An independent central bank and a legislative branch that operate with some kind of discipline, whether it is internally or externally imposed, are necessary for price stability. Throughout history, the temptation has always existed for governments to overspend on wars and other causes that ultimately bring down the regime.

In the era of metallic money, kings would literally debase the coin of the realm by mixing in less valuable elements. In the era of fiat money, the central bank simply has to be coopted into the service of whoever is in charge. As we move into an era of digital currencies, with open-ended consequences, it is only rational to have concerns about the long-term inflation outlook.

We also need to pay very close attention to potentially shifting Federal Reserve mandates that threaten to undermine its independence and historical commitment to price stability. Consider the Federal Reserve Racial and Economic Equity Act, proposed legislation that was reintroduced in August 2023 by Sen. Elizabeth Warren and Rep. Maxine Waters, with ten co-sponsors in the Senate.

The Fed can and should take deliberate actions to help reverse the serious racial gap in our economy. - Sen. Elizabeth Warren

“Equity” in a political context is an amorphous concept that can be weaponized to justify any number of government interventions. Legislative efforts in the name of equity to modify the Federal Reserve’s current dual mandate of subduing inflation while maximizing employment could seriously dilute the Fed’s commitment to keeping inflation down.

Climate change, for example, is often framed as an equity issue because of alleged disparate impacts (in addition to being presented as an existential threat to all of humanity). With the ESG movement, climate change is the lead argument used to justify the prioritization of political and social goals over a corporation’s obligations to its stockholders. It is not hard to imagine our central bank’s priorities being similarly reordered as an extension of this movement.

While the impacts of climate change will be felt by all Americans, they will be deeper and longer lasting among the poor, people of color and other vulnerable populations. - Dr. Rachel Levine, Assistant Secretary for Health

Why seek inflation protection investments?

The future is obviously unpredictable, especially the political environment. While bond markets may be quite comfortable at the moment that inflation can be contained on a long-term basis, expectations can quickly shift.  

One of the main objectives of any investor is to keep up with the continuous deterioration of the real purchasing power of his or her savings that inflation brings. Individuals may have specific circumstances that could make it even more imperative that they find a way to lean into inflation sensitive investments. For example, a retiree living on a fixed income, or someone who has a significant portfolio allocation to bonds.

One could simply be (very justifiably) concerned that the recent break with multi-decade inflation trends is not an anomaly but rather a harbinger of things to come, especially with central bank independence now being challenged so aggressively.

On the monetary policy front, there are also massive unknowns associated with cryptocurrency, the potential introduction of a digital dollar, and how these technology shifts will ultimately affect policy frameworks.

On the wage front, there are various arguments suggesting we have reached an inflection point. The rise of China since the 1990s dramatically expanded the productive capacity of the global economy and brought millions of laborers into the work force, which had a widely recognized disinflationary effect.

Political frictions with China mean we may now be entering a phase of deglobalization and onshoring.  This puts upward pressure on wages, just as baby boomers are entering retirement age and leaving the workforce (a key reason for current low levels of unemployment).  A potential confrontation with China over control of Taiwan could dramatically disrupt access to low-cost overseas labor.

On the commodity front, the decarbonization movement is shifting capital toward massive investments into a new global energy and industrial infrastructure that relies on increasingly scarce resources.

Through a variety of mechanisms from outright regulation and taxation to the soft pressure of ESG, the decarbonization movement is also discouraging capacity investments in the traditional energy sector and other carbon-emitting industries. This all points to a sustained squeeze on commodities from metals to fossil fuels.

If we are indeed headed into a new era of elevated inflation rates, the question becomes, what is the best way to position a portfolio towards such an outcome?

Is gold the answer?

A common inflation protection strategy is to buy gold. We do like gold as an asset class and believe it deserves some space in any portfolio. The central premise of gold as an inflation hedge is that it serves as a store of monetary value and has for thousands of years.

Gold is money; everything else is credit. - J.P. Morgan, speaking to Congress, 1912

Gold still represents the ultimate form of payment in the world. Fiat money, in extremis, is accepted by nobody. Gold is always accepted. - Former Fed Chair Alan Greenspan, speaking to Congress, 1999

Gold investors appreciate that gold has a track record as a financial instrument that is over 5,000 years old. They also appreciate the metal’s unique physical attributes that make it almost the natural choice as a store of value.

Gold is one of the densest metals on the planet, and therefore you need only weigh it to authenticate it. It is inert and therefore does not rust, corrode or decay. It is scarce, with all the gold that has been discovered today theoretically able to fit inside a 23 meter by 23 meter cube (according to the U.S. Geological Survey). Gold is not easy to mine, and therefore supply growth tends to be only around 2% per year (and, unlike other commodities, supply growth is generally inelastic to price changes).

Setting aside the question of inflation protection, gold also has performed reasonably well as an investment.  GLD, one of the primary ETFs that provide investors with exposure to gold, was introduced on November 18, 2004.  From inception through year-end 2023, GLD delivered a 7.9% annualized return versus 9.6% for SPY (an ETF that tracks the S&P 500).

Gold also tends to be less volatile than the stock market. Over the past 5 years, GLD has shown a standard deviation of about 15% versus 21% for the SPY.  (Source: FactSet).

Gold as an asset class has generally performed well over time (notwithstanding its dramatic outperformance and subsequent collapse in the years following the Global Financial Crisis). In this sense, it has functioned well as a store of value over the long-term. But to be fair, as an actual inflation hedge, it has, especially in recent periods, not really delivered.

Gold tends to rise in periods of crisis, which are often periods of low inflation, due to an unexpected drop in demand. One of the reasons for this is the relationship to interest rates.  

In periods of low interest rates, such as a recession or economic shock, the opportunity cost of owning gold is lower, which makes gold look more attractive. Conversely, when you can park your cash in money market funds and earn a decent interest rate, gold is less appealing.

In fact, during the biggest inflationary stress test in a generation, the three-year period from the end of 2020 through the end of 2023, GLD not only underperformed the SPY, but did not keep up with the Consumer Price Index, which increased over 17% during this time frame, versus a 7% total return for the GLD.  SPY delivered a total return during this period of approximately 33%.

How about bonds?

While gold’s utility as an inflation hedge is debatable, we can assert with high confidence that bonds do not work (with perhaps a few potential exceptions). Bonds are, by their nature, securities that offer a fixed schedule of cash flows, sometimes long into the future. When inflation sets in, interest rates typically rise, and bonds decline in value.

Gold failed to keep pace with inflation from 2021 to 2023, but it at least generated a positive return. Long-term treasuries by contrast suffered their worst performance in decades. As reference, TLT, the widely owned ETF that tracks a long-term Treasury index, delivered a total return over the three-year period of approximately -33%.

Even bonds that were specifically designed to protect investors in periods of inflation performed quite poorly.

As mentioned above, the federal government issues Treasury Inflation-Protected Securities (TIPS). Whereas regular Treasuries have a fixed par value at maturity, the par value of TIPS is periodically adjusted on the basis of inflation rates. So when inflation is high, a TIPS investor will receive a larger amount at maturity than he otherwise would. (Of course, a certain amount of inflation is priced into these instruments at all times, so they will generally outperform Treasuries only if the market is underestimating the total amount of future inflation.)  

TIPS did outperform standard long-term Treasuries (which as noted above performed very poorly) from 2021 to 2023, but returns were still very disappointing. TIP, an ETF that tracks a commonly used TIPS index, produced a -4% total return over the three-year period.

The reason TIPS did so poorly, despite the inflation protection mechanism, is that as the Fed pivoted towards a restrictive monetary policy in response to high inflation, real yields went up significantly. It was the expansion of real yields, the rate of return beyond expected inflation required by bond investors, that caused TIPS to lose so much market value.

This brings us to stocks, which were the clear winner (at least relative to gold and long-term bonds) in the 2021-2023 inflation stress test. Despite the terrible performance of the stock market in 2022 as the Fed became aggressively hawkish, over the three-year period, SPY meaningfully exceeded cumulative inflation. If we are in fact entering a new era of structurally higher inflation, there is a strong case to be made to be invested in equities.  

Which stocks work in inflationary environments?

Stocks are ultimately ownership stakes in businesses that in most cases have the ability to raise prices and grow their cash flows along with nominal growth of the economy. In a fiat money world, business ownership is among the best ways to keep pace with the continuous erosion of purchasing power. Businesses operate in the nominal economy. When there is inflation, they are, very broadly speaking, able to pass it through to customers, which means their profits grow in line with inflation as well.

When it comes to inflation, however, not all stocks are created equal. Inflationary environments create a lot of puts and takes that impact share prices.

To understand how individual stocks are likely to be affected by high levels of inflation, it is necessary to think through the impact on 4 main components of the business model: revenue, expenses, assets and liabilities.

(1) Revenue. A business that can increase prices in response to inflationary pressures without sacrificing volumes is well-positioned for inflation. Sales can adjust quickly to offset rising input costs. But many businesses do not have this ability.  In some cases, higher prices could cause their customers to shift their purchasing habits (for example, a retailer of discretionary goods losing share to a discount grocery store as cash-strapped consumers focus on necessities). Certain businesses have their revenue based on fixed rate contracts; these bond-like companies may offer more stability in recessions but tend to do poorly in inflationary contexts.

(2) Expenses. To understand whether inflation will squeeze or enhance profits, it is important to understand whether operating expenses are more vulnerable to inflation than sales. A business that provides inflation protection will be able to raise prices at least on par with, if not faster, than operating costs. But it varies on a case by case basis whether a particular business will see its costs outpace or lag inflation relative to its sales.

(3) Assets. Is a company built around a reserve of physical or intangible assets that will appreciate in nominal value as inflation courses through the economy? Or does it have rapidly depleting assets that need to be replaced, at higher and higher cost? Companies built around scarce resources that do not need to be replenished continuously are likely to fare better in inflationary contexts.

(4) Liabilities. Financial debt in the face of inflation is a double-edged sword. To the extent a company has a lot of debt, inflation diminishes the real value of those obligations over time. For the same reason bond investors hate inflation, bond issuers like it. On the other hand, as we have recently observed, inflation generally leads to higher interest rates.  Depending on the maturity schedule of a company’s debt load, its exposure to fixed versus floating rate debt and other variables, a company might find that the interest rate effect makes rising the cost of servicing debt extremely harmful to earnings and cash flow. Other types of liabilities, like leases, need to be considered as well.

Investors concerned about structurally higher rates of inflation in the future should strongly consider the value of stocks as an inflation hedge, relative to other options. The next step is to think carefully about how to design a stock portfolio that might disproportionately benefit from inflationary trends.  

Following a thorough analysis of the inflation sensitivity of different business models, the 76research Inflation Protection Model Portfolio is drawn from a universe of companies that we believe would fare relatively well against the backdrop of high inflation.

The final holdings represent our assessment of the best investment ideas we can identify at any given time, applying the broader range of considerations that informs all of our investment recommendations, including business quality, growth, balance sheet, governance and valuation.

Disclaimer