Invest: What investment performs well in inflation?

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Inflation, we hear this word a lot recently. What is it exactly?

First of all, inflation is not directly measured. Rather, it is a representation of the Consumer Price Index (CPI). And the CPI for May, 2022 is 8.6%. This is suggesting that if you buy the same things in your local super market in May 2022 vs. May 2021, you’ll have to pay 8.6% more.

How is this number measured? It is measured by the US Bureau of Labor Statistics, who releases monthly report of CPI. And their most recent (May, 2022) report can be found here.

So simply put, for us consumers, inflation means higher prices on goods and services, and the risk of a loss of purchasing power if our income fails to keep up.

So, how inflation affects our investments?

While inflation’s effects on the economy and asset values can be unpredictable, history and economics offer some rules of thumbs.

Inflation is most damaging to the value of fixed-rate debt securities, because it devalues interest rate payments as well repayments of principal. If inflation rate exceeds the interest rate, lenders are in effect losing money after adjusting for inflation.

Longer-term fixed rate debt is more vulnerable to inflation than short-term debt, because the effect of inflation on the value of future repayments is correspondingly greater, and compounds over time.

Simply put, fixed-rate debt security (e.g., fixed rate bonds) is a bad investment choice during high inflation.

Then what asset to acquire then, you may ask. The answer is real estate and commodities.

Real estate becomes a more useful and popular store of value amid inflation while generating increased rental income. Investors can buy real estate directly or invest in it by buying shares of a real estate investment trust (REIT) or specialized fund.

Real estate fared particularly well during an outbreak of persistent inflation during 1970s. But it is also vulnerable to rising interest rate and financial crises, as seen in 2007-2008. And interest rate increases are the conventional monetary policy response to elevated inflation.

Besides real estates, another tangible asset class is commodities.

For centuries, the leading haven has been gold—and, to a lesser extent, other precious metals—causing price to rise as inflation rises. Gold can also be purchased directly from a bullion or con dealer or indirectly by investing in a mutual fund or exchange traded fund (ETF) that owns gold. Investors can also get exposure to a commodity by buying the shares of its producers directly or indirectly through an ETF or specialized mutual fund.

Commodities include raw materials and agricultural products like oil, copper, cotton, soybeans, and orange juice. Commodity prices tend to rise alongside the prices of finished products made from those commodities in inflationary environments. For example, higher crude prices elevate the price of gasoline and transportation. Sophisticated investors can trade commodities futures or the shares of producers. On the other hand, exchange-traded funds investing in commodity futures will tend to underperform the price of a rising commodity, because their futures positions must be rolled as they expire.