We've Got Some Hot TIPS on Fighting Inflation

Ever since the first major increase in money supply after the 2008 housing crisis investors have been bracing themselves for inflation. The only problem is the only thing that seems to have been inflated since then is equity valuations! Don't get me wrong, no complaints here but still, remember when Modern Monetary Theory was just Monetary Theory and was not the only tool the Fed used? In addition to everything else that 2020 gave us, it also set the stage for what is happening now. Optimized just-in-time processes essentially broke last year due to a combination of lockdowns and sick workers. For the better part of 2021, those lower production levels and dwindling inventories have been pushing prices higher. Now that things are returning to normal, the rush to fill orders and container ships has been overwhelming. While the 100+ ship backup of the Suez Canal in March of this year didn't cause these issues, it certainly didn't help. In any event, the October CPI release showed figures (YoY CPI: 6.2%, YoY Core CPI: 4.6%) we haven't seen since 1990 and 1991, respectively. Inflation had arrived and might not be as transitory as the Fed had been claiming. Now that we are essentially in an inflationary environment, how can investors protect themselves by getting ahead of, or even avoiding the effects of inflation? TIPS If you are looking for the safety and yield of U.S. Treasuries and want to keep up with inflation there are a number of Treasury Inflation Protected Securities based ETFs out there. To refresh, these bonds are just like regular Treasuries except the principle amount is indexed to CPI. What this means is that if the notional amount of a bond bought at auction is $1,000 and the first reading of CPI is 2% then that notional amount is adjusted to $1,020 and interest is paid on that new amount. The construction of these bonds essentially guarantees that investors will not be negatively impacted by the effects of inflation (as defined by the Bureau of Labor Statistics, anyway). The 5 basis point Schwab US TIPS ETF provides broad exposure to the U.S. TIPS market and in an era where rates are expected to rise at some point, it is important to note that the fund sports an effective duration of 7.7 years. Another fund with similar exposure is the 18 basis point FlexShares iBoxx 5-Year Target Duration TIPS Index Fund . If you are looking to protect yourself even more against the effect of interest rate increases, FlexShare offers a 3-year duration version as well. IVOL Quadratic Capital hit #1 with a bullet last year as its $3 billion, 105 basis point Quadratic Interest Rate Volatility and Inflation Hedge ETF handily outpaced traditional TIPS products. The fund utilizes both a TIPS strategy and an allocation to over-the-counter (OTC) fixed-income options. As you may remember, volatility plays the largest role in option valuation, and changes in interest rates play the largest role in valuing bonds. This is where the fund gets its exposure to interest-rate volatility. The streak continued through mid-year but has since taken a back seat to a basic TIPS strategy as interest-rate volatility (as measured by the CBOE Interest Rate Volatility Index) fell about 9.5% between May and June on expectations of a steady rate environment. Despite being invested 90% in SCHP (30-Day SEC Yield of 2.40% as of 11/16/2021), the fund is posting a 30-day SEC Yield of 4.08% (as of 10/31/2021) assumedly on the interest-rate volatility exposure. As we move into a rising rate environment my expectation is that rate volatility will pick up and this fund will start firing on all cylinders again soon. Real Estate Traditional theory maintains that real estate is a good inflation beater because property owners have opportunites to raise rents and will, in order to maintain margins. In reviewing the October CPI release we see that Shelter as a category was one of the slowest-rising components, posting a YoY rise of 3.5%. I believe this has more to do with the eviction moratorium initiated by the CARES Act of 2020 and replaced by the CDC's eviction ban as well as support provided to tenants via the American Rescue Plan. These plans are helping keep tenants current in their existing leases, which is good but doesn't offer property owners an opportunity to turn over new tenants or otherwise raise rents. On the commercial side, it looks like office space is currently in glut territory and maybe there for some time as many companies are getting used to employees working from home as well as the reduced overhead. All this to say that while broader market REITs may not be the safe haven they have been in other cycles there are some bright spots like the 60 basis point Pacer Benchmark Industrial Real Estate SCTR ETF , which focuses on owners of properties that support e-commerce like storage warehouses, fulfillment centers and, data centers. Gold Another asset that is often touted as an inflation hedge is gold. While gold has its place in a portfolio's allocation mix, I'm not convinced that it's a silver bullet of sorts when it comes to fending off inflation. That being said, as we do get into an inflationary period, rates are usually hiked in an effort to stop the economy from overheating and the effect on the markets is chilling, sending investors to safe havens and gold is usually one of them. From that perspective, I would say that gold is a good hedge against the effects of trying to control inflation but not against inflation itself. Gold has been in historically high valuation territory for the better part of the past year or so although it has come off its August 2020 $2,000+ high to a $1,860 handle recently. One can only assume that as we get closer to the Fed taking action on rates that gold will start to rise again. There are a number of physical gold ETFs to choose from these days. If you're looking to go with the crowd then the 40 basis point SPDR Gold Shares would be your ticket. If you are looking for less expensive exposures the 18 basis point SPDR Gold Mini Shares Trust , Goldman Sachs Physical Gold ETF , or the 17 basis point Aberdeen Standard Physical Gold Shares ETF all seek to provide the same exposure. Final Thoughts The catalyst for this bout of inflation seems to be supply related. Specifically, supply-chain related. From my perspective, this is a good thing because unlike in the past where it would have taken a roomful of economists to theorize a potential solution there are some real actions we can take to relieve these pressures. First, work through port backlogs and make adjustments to throughput capacity. Second, if Great Resignation trends are becoming more entrenched, companies will need to figure out ways to incentivize the labor force back to work. These actions won't resolve the issues overnight but at least the high-level steps we need to take are fairly clear and straightforward. Until these steps are taken, and we see inflation begin to recede, one of these approaches might be a suitable solution for you, depending on your risk tolerance.

We've Got Some Hot TIPS on Fighting Inflation

Now that we are in an inflationary environment, there are many ways investors can protect themselves by getting ahead of, or even avoiding the effects of inflation.

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