While encouraging news on the economic recovery from the pandemic is obviously a good sign, it is, unfortunately, being accompanied by increasing inflation. The lifting of pandemic restrictions and the return to business as normal, combined with federal stimulus packages, have fueled the economy. So far, so good. However, the downside of this growth is rising inflation. Prices on a wide range of goods are rapidly increasing – in addition to house prices and fuel costs – making the cost of living notably higher for most Americans. This surge in prices results from issues with supply chains, leading to shortages of essential goods, as well as labor shortages as a result of pandemic-related changes in the employment dynamic. As such, the current surge may be temporary – or it may not. Investors wishing to protect their portfolios must look at alternatives to find inflation-proof investments.
Alternative investments have played a major role in creating and maintaining diversity in portfolios for many years now and traditionally provide good protection against inflation. Assets such as: TIPS; company stocks; real estate; commodities, especially energy, agricultural products, precious metals and industrial metals; and cryptocurrency all offer diversity and some inflation protection as part of a portfolio. But not all alternatives are created equal and some will definitely offer better protection, both short and long term, than others. Assets that are truly inflation proof need to be tangible, appreciate over time, and offer variable rates of interest.
Treasury Inflation-Protected Securities (TIPS)
The name definitely suggests protection against inflation but a little caution is needed.
PRO
- The inflation proofing works well in theory as the value of the bonds rises along with the rate of inflation, so maintaining value in ‘real’ terms.
CON
- A reasonable amount of anticipated inflation, such as the US is currently encountering, is already built in to the yields, so investors may not see large profits. (A Wealth of Common Sense, Ben Carlson – March 11, 2021)
Stocks
PROS
- Stocks have been riding high in recent months, with the markets soaring.
- Historically, stocks have outperformed inflation quite impressively.
- Company stock should appreciate, making it a reasonable inflation hedge.
CONS
- In the event of an ultra-inflationary environment, the stock market may show below-average returns, and stocks can also be volatile.
- Given recent large gains, many investors fear that they have missed prime buying opportunities and that they would now be purchasing at the top of the market.
Commodities
PROS
- Commodities are likely to appreciate as prices rise, especially agricultural products and oil and gas.
- Industrial metals should also appreciate, as they are used in the manufacture of many essential goods and infrastructure projects.
CONS
- Investors are being discouraged from investing in fossil fuels with greener alternatives being preferred choices – a personal matter for each investor’s conscience, obviously.
- While industrial metals may do well, precious metals are less predictable – gold, for example – traditionally considered a safe inflation hedge – actually tends to do best as an extremely long-term investment.
Cryptocurrency
PRO
- Cryptocurrency has certainly produced encouraging results for investors so far.
CON
- It is still a relative newcomer to the alternatives sector so there is little historical evidence as to how cryptocurrency may perform during periods of inflation.
Real Estate
PROS
- Traditionally, real estate outperforms inflation pretty consistently, offering investors a considerable benefit in offsetting inflation.
- Real estate offers a tangible asset that appreciates reliably over time and even more rapidly during periods of inflation. As inflation pushes house prices up, so the loan-to-value ratio of mortgages decreases and equity increases. This works favorably in terms of long-term growth, both for individual homeowners and investors. Commercial real estate, whether residential or industrial, also experiences reliable appreciation.
- Investors in commercial real estate will also reap increasing returns on their rental properties when inflation hits, particularly when compared to more traditional investments. (Forbes.com, David Wieland and Forbes Biz Council – September 28, 2021)
CON
- Illiquidity – real estate takes time, and costs money, to sell. However, the appreciation and reliable income (from rental properties) likely more than compensate for the lack of liquidity.
“Currently, high-quality private commercial property yields exceed those of high-quality bonds, providing a larger potential income cushion to … offset inflationary impacts.” – Mark Dixon, Jim Baird, Worth, October 6, 2021
Real estate, both residential and commercial, meets the three requirements for inflation-proof investments perfectly – it is tangible, has high levels of appreciation, and interest rates are generally variable. As always, some sectors of the commercial real estate market are likely to perform better than others: warehousing, private storage facilities, medical buildings, and multi-family rental buildings all perform very well in uncertain times. Such investments will generally offer secure long-term rental income, while also appreciating in value.
Private Credit
Private credit provides high yields and low volatility, with investments often being in commercial real estate or companies with high growth potential. Currently, close to $1 trillion of capital is held in private credit.
“Private credit is on a roll. Investors love the strong cash yield and return potential, as well as the diversification and risk mitigation it can bring to a portfolio.” – Institutional Investor, July 13, 2021.
PROS
- Private lenders can access a wide choice of deals and are, therefore, able to select only the best.
- Some projects that attract private credit are short-term, allowing for profits to be realized quickly.
- Private loans are not publicly traded, so they experience less volatility.
- Floating rates help to offset the effects of inflation, where fixed-rate investments will devalue.
- Yields are higher in the private credit market as borrowers are often looking for short-term loans, perhaps for business development or to complete a real estate purchase quickly. Private lending can produce very high returns, with some lenders charging as much – at the higher end – as 20% interest, and an average of around 10%. Interest rates will vary depending on the perceived risk of default.
CON
- Risk of default is arguably higher in the private credit market; however, the ability to choose borrowers carefully, and the wide choice of borrowers to choose from, should mitigate risk considerably for knowledgeable investors.
Investors looking to enhance portfolio diversification while also protecting themselves from the effects of inflation will seek out variable rates, and tangible assets, while also looking at capital growth and historic appreciation, both long and short term. Alternative investments can all offer diversity and risk mitigation for portfolios; however, in times of inflation, real estate and private credit perfectly satisfy the above requirements for reliable inflation proofing, with minimal risk.