How Inflation Impacts Your Investments

Broadly defined, inflation is the increase in prices over a period with the underlying premise that a specific amount of currency (i.e., the dollar) will be able to buy less than before. In an inflationary environment, a loaf of bread that once cost $2 may now cost $3.

Some inflation is expected as the price of goods naturally increases over time as demand increases due to, for example, population growth. Some inflation is good. How?

With the expectation of inflation, people will buy now rather than pay more later because they want to take advantage of lower prices now.

People will buy this year’s iPhone because they know it will cost more next year. This increases demand in the short term. As a result, stores sell more and factories produce more now. They are more likely to hire new workers to meet demand. This boosts economic growth.

On the flip side, too much inflation can be bad, very bad. If left uncontrolled, inflation can be destructive.

For example, over 20 years, an increase of $2 to $3 seems reasonable. That’s an annual increase of 2.5%, which happens to be the average inflation rate over the past 20 years. Over a shorter period – say, only one year – that same 50% increase would be destructive.

There are two main drivers of inflation:

  1. Demand.
  2. Currency Devaluation.

Economic growth can drive inflation as demand for goods increases and companies begin to raise prices for their products.

Currency devaluation (i.e., monetary debasement) occurs when a country overprints money, in turn, devaluing the currency.

Undisciplined monetary policy can result in hyperinflation like in Venezuela.

In 2016, Venezuela entered hyperinflation. The inflation rate reached 274% in 2016, 863% in 2017, 130,060% in 2018 and 9,586% in 2019. Since 2016, the overall inflation rate has increased to 53,798,500%.

What was the result of hyperinflation in Venezuela? Complete economic collapse.

Hyperinflation in Venezuela has been accompanied by chronic shortages of food and medicine, which has impoverished almost all of the country’s 31 million people. Nine out of 10 Venezuelans do not earn enough money to buy sufficient food. Overall, Venezuelans have lost an average of 24 pounds each. More than 2.3 million Venezuelans have fled the country, including more than half of the nation’s doctors.

In the U.S., investors are starting to worry about a surge in inflation – haunted by Venezuela – as Congress and the Federal Reserve have teamed in recent months to pump more than $2 trillion into the U.S. economy through the Cares Act and Fed liquidity provisions as part of the economic stimulus package launched in response to the COVID-19 pandemic.

Even during normal times, where it can hover in the 2.5% range, inflation is a wealth eroder.

Imagine putting $1 million under your mattress. That $1 million will be worth 2.5% less each year you leave it under there. In ten years, it will only be worth $776,329.62. Now imagine the eroding power of inflation at rates higher than 2.5%.

How do you protect your investments against the eroding power of inflation?

Some investments do well in the face of inflation and some can perform just as bad or worse than putting your money under the mattress.

A recent Wall Street Journal article studied the correlation of the returns of certain assets to inflation over the past 50 years. According to the article, the more closely an asset’s returns track the course of inflation, the better the asset serves as a hedge.

Not surprisingly to savvy ultra-wealthy and institutional investors who have known this for years, tangible assets like real estate – as specifically pointed out in the article – correlated best with inflation. In other words, returns on hard assets like real estate rise as inflation rises.

On the other end of the spectrum were stocks and bonds, which fared the worst relative to inflation – showing negative growth relative to inflation. In other words, inflation goes up, stocks and bonds go down.

So why are is a hard asset like commercial real estate an ideal hedge against inflation?

Because as a hard asset that is supply constrained (in other words, you can’t make more land), rising prices increase the resale value of commercial real estate over time.

The bonus of commercial real estate is that just as the value of the property rises with inflation, the amount tenants pay in rent can also increase over time.

Commercial real estate stands out from other hard assets because not only does it appreciate over time, but because cash flows, income also rises – providing a double hedge against inflation.

We live in chaotic economic and social times and it remains to be seen whether a period of high inflation is in our future, but with more fiscal stimulus on the way and no end in sight to the Fed’s bond-buying program that’s dumping more and more money into the economy, investors shouldn’t wait for the other shoe to drop.

Investors should be taking steps right now – if they haven’t already – to protect themselves against the possibility of high inflation.

If the past 50 years have taught us anything it’s that hard assets like real estate fare far better in the face of inflation than stocks and bonds, which have been shown to move in the opposite direction.

So Don’t WAIT!

Hedge Against Inflation NOW With Hard Assets

 

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