Hedging Inflation with ETFs

You have seen the doomsday headlines. The Fed is printing money and government debt has ballooned. This can only mean one thing: inflation, right? In this article, we offer some tips on how to hedge inflation risk using various ETFs. We then take a look at the prospects for inflation and explain why we feel the risk is overhyped.

Hedging Inflation Risk
Money has three central purposes. It serves as a medium of exchange, (prevents the need to go back to the barter system), it is a unit of account (a method to value transactions or measure worth), and it serves as a store of value (this is what concerns investors most). So the best way to protect ourselves from inflation is to store wealth in something that is of fixed supply that cannot be easily manipulated.

So to hedge the risk of inflation, we want to have ownership stake in assets rather than paper currency. One option is to invest in equities through a fund such as  Vanguard Total Stock Market ETF (VTI). The problem with investing in equities is that although a firm's assets and revenue should increase in value with inflation, there is the potential for these values to fall due to the negative impact on profitability due to inflation. Some estimates even show a negative relationship between stock returns and inflation. Even though stock prices and earnings are both quoted in nominal terms, the price/earnings ratio can shrink. For example, we have seen gasoline refiners suffer from their inability to pass along high oil prices. However, over the long term, firms and consumers will adjust to inflation and nominal stock prices should reflect higher inflation. A similar argument could be made for funds that invest in real estate, such as  iShares Dow Jones US Real Estate (IYR). Although the value of the land should keep up with inflation, in the short term, the economic disruption caused by real estate could have a negative impact on rental income.

Another option is to invest in commodity ETFs like  SPDR Gold Shares (GLD). Gold is an ideal commodity hedge because the global supply is relatively stable (at least more so than IOUs written on scraps of paper). An advantage of GLD is that it owns physical gold, rather than entering into futures transactions, which can be an impacted from the negative roll yield associated with contango. Despite the fact that an inflation hedge should be only a small portion of your assets, perhaps 5%, now may not be the best time to buy gold. During the past 10 years, the S&P 500 has lost 8% while gold is up 350%; that trend is clearly not sustainable, particularly when commodities do not generate profit growth or create innovation and their prices tend to be mean reverting.

Another option for hedging inflation risk is through bonds.  IShares Barclays TIPS Bond (TIP) holds bonds that will increase in par value with inflation. Their quoted yield looks lower that ordinary bonds but that is because it is a real rate of return, which will be supplemented with the inflation rate after the fact. As we mentioned above, these bonds are not currently pricing in an inflation crisis. Vanguard Short-Term Bond ETF (BSV) offers only a nominal rate, not an inflation-protected real rate, but because it is invested in short term bonds, the rate resets often so it will increase with inflation with little capital loss. Long-term bonds, on the other hand, can suffer a large capital loss due to unexpected inflation.

In order to reduce the risk of one single currency losing value, you could hold a diversified basket of currencies. Probably the best option among foreign currency related ETFs is  SPDR DB International Government Inflation-Protected Bond (WIP), which offers two forms of inflation protection through the TIPS bonds as well as through currency diversification. Foreign currency exposure could also be obtained through  iShares MSCI EAFE Index (EFA), although this would entail the same problem of a lack of a strong relationship between inflation and equity returns mentioned above.  PowerShares DB G10 Currency Harvest  provides currency exposure, but because it follows an active approach, there are no guarantees it will perform well when the dollar weakens. PowerShares DB US Dollar Index Bearish (UDN) uses futures contracts to bet against the dollar, so it should do well if inflation is higher in the United States than it is abroad.

 

The Prospects for Inflation
In response to the Great Recession, the Fed has purchased debt obligations from the government, the mortgage market, and even from insolvent financial institutions. It has done this on an unprecedented scale all in an attempt to stabilize the financial markets.

To some degree, they are monetizing existing debt, which means they are paying the bills of the government by printing money. In simple terms, printing money without actually increasing the total amount of goods and services available is inflationary. However, the Fed has embarked on this program not with the intent of financing government spending, but instead to prevent deflation, which is the bigger concern.

To quantify this point, take a look at the government statistic known as M2, which is a measure of money supply that includes currency in circulation plus amounts in checking and savings accounts. By this measure, the money supply has grown over the past two years at only a 5% annualized rate, below its long-term average of 7% and the 13% rate seen in the inflationary late 1970s. While it is true that the Fed's balance sheet has grown faster than this, which means that banks are sitting on excess reserves, the Fed will attempt to remove this liquidity once the threat of deflation recedes.

Inflation is not only caused by an increase in the money supply, it can also be caused by the expectation of inflation. For example, if you believe that inflation is going to make your money worth less in the future, you will likely demand a raise today. Unfortunately, it is difficult to get a raise if there is slack in the labor market and your boss can easily replace you with someone willing to work for less.

Without an increase in wages, producers will find that their price increases won't stick. If producers increase prices while wages are flat, consumers will be forced to buy fewer goods, which in term will reduce GDP growth. As long as the unemployment rate remains elevated, there is little chance of wage pressure causing inflation. Another factor supporting low inflation is the low rate of capacity utilization. Similar to the unemployment rate, as long as there is slack capacity, manufacturers will be unable to increase prices. Capacity utilization is currently about 71%, still lower than at any point during the last two recessions, despite the fact that we are officially no longer in a recession.

What about the growing federal debt and the temptation for the government to inflate the problem away? While inflation may sound like an appealing solution to the problem of high government debt, it is politically undesirable. Senior citizens living on a fixed income will put tremendous pressure on politicians not to allow inflation. While inflation may lower the value of government debt outstanding, it would increase the cost of servicing that debt and it would do nothing to tackle the larger government obligations resulting from entitlements such as social security and Medicare.

If you don't subscribe to the view that inflation will be mild, we can take a look at the market's view. In establishing expectations about future inflation, people use their current experience, so inflation tends to exhibit hysteresis or inertia. However, we have a better way to estimate people's expectation about inflation beyond extrapolating the past by looking at the implied inflation rate in Treasury Inflation-Protected Securities. Expected inflation can be approximated by subtracting the TIPS yield from the Treasury bond yield of similar maturity. By this method, five-year TIPS are currently pricing in an inflation expectation of only about 1.5%. We can price forward expected inflation by looking at 10-year bonds. Here, we see that expected inflation is priced to rise only to 2.5% five years from now.

In summary, ETF investors have a number of options to hedge the risk of inflation but they are not without risk. Investors should keep no more than a small portion of their wealth explicitly as an inflation hedge and keep in mind that the current risk of inflation is likely lower than popular perception.

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