VIDEO: Inflation Hedges Are Gaining in Popularity
Welcome to my video presentation for Friday, July 9. My article below examines the video’s themes in greater detail.
Inflation is the hot topic on Wall Street right now. For insights, let’s ignore the loud, obnoxious hosts on financial television and turn instead to a genius I studied in college: British economist John Maynard Keynes.
Keynes is a giant in the field of economics. Simply put, Keynesianism is a “demand side” theory that calls for greater government expenditures to stimulate demand during times of economic distress. This stance is often referred to as “priming the pump.”
The Keynesian approach was considered mainstream thinking for decades, but it’s controversial nowadays (I’ll probably get hate mail from the acolytes of Ayn Rand). However, during the coronavirus pandemic, we’ve seen how priming the pump can prevent an economic collapse.
Below, I look at another concept introduced by Keynes and apply it to current market conditions, particularly inflation.
In the meantime, worries that economic growth would sputter weighed on the stock market Thursday. The Dow Jones Industrial Average fell 259.86 points (-0.75%), the S&P 500 declined 37.31 points (-0.86%), and the tech-heavy NASDAQ slipped 105.28 points (-0.72%). Asian and European stocks swooned as well. The CBOE Volatility Index (VIX), aka “fear index,” jumped more than 17%. Bonds saw their prices rise and yields fall. For anxious investors, “risk off” was the order of the day.
Another factor spooking investors is the rise of the COVID delta variant, which suggests that the pandemic is far from behind us.
The VIX rises during periods of extreme uncertainty. Notably, the VIX spiked in the fall of 2008, near the height of the global financial crisis.
In pre-market futures trading Friday, the three main U.S. stock market indices were bouncing back. Bond yields were rising again. Overseas equities were recovering in early trading.
The post-election stock market rally remains intact. Stocks probably will get a shot in the arm next week, as second-quarter corporate earnings start to come in. Operating results for Q2 are expected to be robust.
But inflation worries won’t go away anytime soon. If you haven’t already, you need to adjust your portfolio to this prevailing sentiment, pronto.
The beauty contest…
Back in 1936, when he was advising FDR during the Great Depression, John Maynard Keynes evoked the metaphor of a beauty contest to describe the stock market. He described a newspaper contest in which 100 photographs of faces were displayed. The winner would be the reader whose list of six came closest to the most popular of the combined lists of all readers.
The shrewdest strategy, Keynes advised, isn’t to pick the faces that are your personal favorites. It’s to select those that you think others will think prettiest.
Accordingly, it’s a sophisticated understanding of crowd psychology that helps you pick stock market winners. Various 2021 outlook reports from some of the world’s biggest money managers tell us that inflation hedges will be the prettiest of all assets in the beauty contest for investing dollars.
Inflation also is the number one concern expressed in reader emails to me. You need to add inflation protection to your portfolio, while it’s still affordable.
Higher inflation is indeed occurring, although I agree with the Federal Reserve that it’s transitory. Historically, inflation remains comparatively low and doesn’t appear strong enough to compel the Fed to tighten the monetary spigot this year. The Fed’s Federal Open Market Committee currently forecasts that the U.S. inflation rate for 2021 will average at around 2.45% (see chart).
But remember our beauty contest metaphor. You should always remain aware of what large investment houses and asset managers are thinking, because they tend to set new trends given the sheer size of their trades. The major institutional investors are currently gobbling up inflation hedges, which means that independent investors who act too late may get crowded out of buying inflation-proof securities at reasonable values.
While each individual investment should always be evaluated using an objective method, such as price-to-earnings ratio, discounted cash flow and return on equity, it’s also wise to follow the macrotrends that are shaping the investment universe.
Higher energy costs, especially at the gasoline pump, are starting to worry investors that maybe the economic recovery is at risk. To be sure, soaring crude oil prices and a fast-mending economy are helping the energy sector post the stock market’s biggest gains so far in 2021. An even stronger performance for energy equities probably lays ahead.
But it doesn’t help market sentiment that in Bloomberg’s June inflation survey, the consensus of economists again called for higher inflation this year (see chart).
Burgeoning demand for Treasury Inflation-Protected Securities (TIPS) confirms that U.S. inflation expectations are rising, with central banks and investors seeking insurance against the prospect that a recovering American economy will stoke price pressures. The market for TIPS has grown to a whopping $1.6 trillion.
While the coupon rate attached to these securities is fixed, the principal is not. The principal is indexed to the consumer price index and appreciates in tandem with inflation. As the principal increases, so do your semi-annual interest payments.
At maturity, you receive either the original face value of the instrument or the inflation-adjusted principal, whichever is greater. Income and gains are exempt from state income taxes.
TIPS aren’t the only investment that is being targeted for inflation protection. Chief among these inflation hedges: commodities. Prices for commodities have been soaring this year and they probably have further to run.
To combat inflation, any given commodity should demonstrate two characteristics: 1) It’s geared to global growth, and 2) demand exceeds supply.
Red metal rising…
A vital commodity that fits these two criteria is copper.
The industrial world can’t function without the “red metal.” Copper is vital for building construction, power generation and transmission, electronics, industrial machinery, and transportation vehicles. Copper wiring and plumbing are mainstays of heating and cooling systems, appliances, and telecommunications links. Renewable energy and electric vehicles consume vast amounts of copper.
This year and beyond, as the world economy speeds up and infrastructure spending explodes, so will demand for copper. For our favorite investment play on this crucial commodity, click here now.