Best Hedge Against Inflation?

What’s The Best Hedge Against Inflation?

In case you have been living under a rock, which candidly doesn’t sound so terrible, inflation has been making some noise recently.  Correction, it’s been making a ton of noise these days.  If you don’t believe me, go fill up your tank of gas or buy a used car and you’ll know what I’m talking about. 

Living in a world without room for nuance, everyone wants to attribute this to one thing. The reality is its several issues, which range from strong domestic demand, supply chain issues, and geopolitical conflicts.  All these items, and a bunch more, have left us in an inflationary period not seen in decades.  While inflation isn’t necessarily bad as the regulatory bodies target a 2-3% annual rate, persistently high inflation is something of concern in our economy.  This is why the Fed is being very aggressive, at the expense of economic growth, in raising interest rates.

The natural question is how do we protect ourselves, and our purchasing power, from inflation over the long term?  I’m so glad you asked…

What is Inflation?

Let’s take a little step back before we move forward.  Inflation generally happens when the cost of goods and services increases.  As I mentioned above, we are in a unique time period as there are a couple of underlining factors at play.  For starters, the economy is really strong right now.  We have 3.6% unemployment, and employers (like Diversified), can’t find candidates to fill jobs quickly enough.  In turn, qualified applicants are requiring higher wages from employers.  This is a longwinded way of saying there is really strong demand for goods these days.

To add fuel to the fire, there is also a major supply issue.  We are still experiencing a backlog from Covid supply issues, and on top of that China has completely shut down its economy due to current Covid rates and this hope of a zero-Covid policy.  Lastly, the war in Ukraine has put pressure on commodities, namely oil, gas, metals, and agriculture.  

In most inflationary periods we may experience one of these issues, but today we have hit the perfect inflationary storm.  Now my next comment is going to shock a lot of you as you may not like it.  So what is our best long-term hedge against inflation?

STOCKS!

Oh man he did it, this dude mentioned stocks.  I know that is what you are all thinking, but in all seriousness it is true.  Historically speaking, stocks have been one of, if not the best, long-term hedges against inflation.  I know it is a very taboo thing to say, especially as I am writing this blog after a thousand-point sell-off in the Dow Jones Industrial Average.  But, and there is a big but, it doesn’t change the fact that this is how we best protect in an inflationary environment.

Now, we have to put our emotional hats aside otherwise your head may explode.  I know things are tough right now, and watching the markets fall is painful for us all.  That said it doesn’t change the playbook for how to best hedge or protect yourself against long-term inflation.

For a second, let’s think about this all very logically.  When you own stocks, you are owning what?  That is right, publicly traded companies.  And what do these companies do?  Yup, produce a good or service.  Now if I am a public company and the cost of goods goes up for whatever reason what do I have to do?  Pay more for those goods.  Now, these companies aren’t in the business of losing money.  If the cost to run their businesses and produce their goods goes up, guess who is left holding the bag?  You got it, us consumers.  The successful businesses in this period will be the ones who can pass input costs through to the consumer.

Follow the Money

Let’s follow the money.  So, companies’ costs go up and thus must charge more for their goods and services.  The economy still wants to buy those goods and services, so naturally, they’re willing to pay more to these companies.  These companies then report their earnings and guess what happens?  You got it, their top-line revenue goes up, bottom-line earnings stay strong, and thus so does their stock price.  While this is a very basic example, this is why stocks offer a great hedge against inflation.

Commodities and Inflation

I know some of you are screaming at me that I’m not talking about commodities and their relationship to inflation.  Here’s the rub with commodities – in short periods of time, inflation is often driven by a temporary increase in commodity prices.  So naturally many investors want to own them for that property, but history has shown us that commodities are a very inefficient asset class. What I mean by that is over the long-term, returns for a basket of commodities (using the Bloomberg Commodity Index) underperform global equity markets with similar risk. That’s very inefficient. So while commodities can help in very short bursts, stocks have provided some of the best purchasing power protection.

Short-Term Events vs Long-Term Planning

Now, I know it may take a little bit of time for things to bottom out and rebound, but we must not let that deter us from what we know fundamentally works.  As the old saying goes, don’t let short-term events and decisions impact your long-term planning.  In my 20-plus years of industry experience, these are the times to lean on good advice, a team of experts, and fundamentals. 

Stay wealthy, healthy, and happy.