Fear of inflation? Read here to find out why, what, and how to protect yourself?

Inflation is measured by the Consumer Price Index, which measures the average change over time in prices paid to consumer goods and services. The Federal Reserve has a goal of 2.5% average inflation in 2021, and Fed Chair Jerome Powell and Treasury Secretary Janet Yellen think the recent rise in consumer prices is temporary. But should you be fearful? How does it affect you? And what can you do? First, let us take a look at the latest CPI numbers as of April 2021.

Data Source: US Bureau of Labor statistics

I noticed that CPI for all items rose 0.8% in April, and energy, used cars and trucks, and airline fares rose the most among all indexes. But basically, everything is up. I also noticed inflation is making many investors worry, contributing to the market volatility in the first half of 2021.

In this article, I will address what inflation means to you in three ways:

1. Why is inflation bad? 2. What are the hedging strategies in response to rising inflation? 3. How do we protect ourselves?

1. Why is inflation bad?

A. When inflation is up, tax is up. Personal and corporate income is subject to taxation. When the cost-of-living adjustment or price adjustment increases, we can also expect marginal tax brackets to go up because it is readjusted for inflation. Inflation is a valid concern when your income goes down or stays the same, but the marginal tax brackets are up.

B. The rapid increase in inflation can impact stock market return. When inflation rises, the rate is perceptibly expected to be smaller than for stock appreciation. But when investor fears stock price can’t go up more than the presumed inflation, investors start to worry. Even a positive return on the securities is viewed as negative real return. It may be a valid concern because this theory is based on evaluating different hypotheses such as central government policy, the impact of GDP improvement when allowing inflation to rise temporarily, or interest rate tendency, etc.

C. Inflation increases the cost of production. Some companies are subject to higher price of goods and services for the increased cost of production, labor, or equipment replacement. Naturally, it means PPI (Producer Price Index), a gauge of industrial profitability, can also rise. It is a valid concern. But given the historically low-interest-rate environment, I think most companies will take on finance options to fund the cost rise in response to inflation.

D. Inflation can affect retirees or Americans living on a fixed budget. When inflation is higher than the earnings adjustment, one brings home the same money with less purchasing power. If you live on a fixed income or low income without the adequate cost of living adjustment, it is a valid concern with buying fewer goods and services with the same amount of money.

What are the hedging strategies in response to rising inflation?

A. Real estate offers some protection against inflation. Note that higher housing prices do not affect everyone the same—a homeowner who sells the house benefits from higher price. A homeowner or a commercial property owner holding on to the current inventory can also hedge inflation. So depending on the scenario, real estate investors would offer some level of offset against inflation in utility costs, insurance, taxes, etc.

B. Gold and other commodities (copper, platinum, etc.) are standard hedging options in raising inflation. For the most part, Gold is the best insurance against inflation because the price of Gold tends to mirror the fear of inflation. But why is Gold still down? I believe it has to do with investors seeing Gold's incapability to track real interest rates correctly. Another way to look at this is that when our expected inflation is rising while Gold does not pay interest, investors do not feel Gold can reflect the actual inflation. This is the reason why Gold is down.

C. Inflation-indexed securities, referred to as TIPS (Treasury inflation-protection securities), is another investment vehicle for an inflation hedge. TIPS are usually purchased to manage purchasing power risk associated with inflation. These types of bonds pay a modest rate of interest and adjust the rate of inflation. There are two basic types of marketable federal government inflation-indexed debt. The first note is issued annually on January 15 and July 15 and mature after ten years. The second is the inflation-indexed bond, which is 30-year security issued every October 15. They are currently the type of investment that gives the most comfort presently to hedge rising inflation. However, the Fed is also buying up the TIPS whether you know or not. When the Fed begins other yield curve control or Federal money tapering, TIP usually does poorly.

D. Cryptocurrency is not a typical inflation hedge strategy, but some do consider it is. The crypto exchanges surged from less than $100 billion in April 2020 to $1.7 trillion last month based on data from The Block Crypto. Cryptocurrency is highly volatile, and even most economists I come across do not understand the fabrication around this technology, let alone assessing the risk and potential. In my experience talking to hundreds of people, I found that the younger generation sees this as an inflation hedge, eating Gold's lunch. I can also see now that some big institutions were buying up a small percentage of Cryptocurrency for diversification purposes (Telsa is just one example). If this trend continues, I remain skeptical but not cynical when evaluating Cryptocurrency as an inflation hedge. But I must emphasize that Cryptocurrency is not a safe haven either.

3. How do we protect ourselves from inflation?

A. A healthy and diversified portfolio mix is exceptionally imperative. If you already implemented a hedging strategy, there is no reason to worry. On the same token, continue to cost average on a good quality dividend-paying stock. Holding bonds and cash in a low-interest-rate environment can also give you a negative real return. You must not throw the towel and give up diversification. Remember, the Fed can't adjust the yield upward right away because it will hold back the economic recovery. Also, it is not true that the ups and downs of stock movement in response to inflation mean the same for all stocks. For example, Airfare and lodging price went up, but if you look at the data before and after the pandemic hit, the airlines are steadily returning to the regular pricing. Therefore, we cannot conclude the CPI upward movement means hyperinflation in all industries.

A. Stay disciplined with a portfolio diversified in all asset classes and all industries; there is no reason to time in and out of the market based on inflation concerns. Remember some years ago, stock prices rose more than the rate of inflation (e.g., 1995-1999), so that investors experienced a positive absolute return during that period. Then, there were years in which stock prices fell while consumer prices continued to rise (e.g., 1984 and 2000-2002). There was also a year in which stock prices increased, but not when consumer prices increase.

B. High-quality bond and dividend-growth stocks are still in demand. At the same time, I understand that it may be difficult to justify holding stocks or buying stocks when inflation is up. I can also argue that keeping a basket of good quality stocks are better than holding no assets and cash. A good stock can offer a reasonable inflation premium to hedge inflation. A fundamental analyst who follows general logic thinks differently. But in this macroeconomic environment, we ought to behave dimensionally to address inflation.