Which Inflation Protection Strategies Worked and Which Didn't?
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Audible. There's more to imagine when you listen. Go to audible.com slash imagine and discover all the year's best waiting for you. Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I'm your host, David Stein. Today is episode 429. It's titled, Which Inflation Hedges Worked and Which Didn't?

Two years ago, in the spring of 2021, we released a number of episodes on the risk of higher inflation and on investments that could help protect against inflation. An investment protects against inflation if it generates a return greater than inflation. In this episode, we want to review how those inflation hedging strategies actually worked. Did they outperform the inflation rate, allowing investors to maintain the purchasing power of their assets?

First, what has been the inflation rate? I use the CPI inflation calculator provided by the Bureau of Labor Statistics. It's based on the Consumer Price Index for all urban consumers, known as CPIU.

That reflects the average price in U.S. cities for hundreds of goods and services that are purchased for consumption by households. That inflation calculator, $100 in March 2021, has the same buying power as $113.95 in March 2023. That means inflation has increased just about 14% on a total or cumulative basis.

For an investment to have outpaced inflation over the past two years, it needs to have a cumulative return, a total return of over 14%.

Two years ago, the financial markets, they weren't pricing in high inflation. We looked at the five-year inflation rate as reflected in inflation protection securities. Those tips were priced assuming an inflation rate of 2.5% per year for the next five years. Now, again, that was two years ago. We've had

inflation of 14% over the past two years. In order to get a five-year average inflation rate of 2.5% when you've had 14% the first two years, you basically need prices to not increase at all, actually even fall a little bit in order to meet that. And that's just not going to happen. Well, it could, not likely.

If we look at current expectations for inflation, looking out five years as reflected in TIPS prices, they're priced at a 2.4% annual inflation rate over the next five years. Now, we don't actually have the two-year expected inflation rate from two years ago.

The U.S. Treasury provides real rates, which we can compare to nominal rates to figure out what that embedded inflation rate is. So we can look at what's the current real rate of, let's say, five-year tips are around 1.2%. And then we can look at the five-year nominal yield, which is around 3.6%. And that difference is 2.4%, or what's known as the break-even inflation rate.

Suffice to say, we know that two-year inflation expectations two years ago were not for the 6% to 7% inflation rate we've seen. What we do know, though, is what the Federal Reserve Open Market Committee was expecting inflation to be two years ago. The Federal Reserve Open Market Committee, or FMOC for short, they meet eight times a year. The chair is Federal Reserve Chair Jerome Powell, and the committee members are members of the different Federal Reserve banks around the country.

They meet, and they'll meet again in early May, and they look at current financial conditions, economic conditions. They'll be discussing the situation with the banks and the deposit outflow. Then they decide the appropriate monetary policy. What should be the policy rate? The rate for short-term interest rates, the rate they pay on reserves held at the Federal Reserve. And that flows through to the interest rates for one year, three-year, five-year, and so on.

They'll decide that, and they have been raising that rate over the past year. But back in March 2021, they were not. The rate was effectively zero, the Fed funds rate.

After the March 2021 FOMC meeting, Federal Reserve Chair Powell had a press conference in which he said, overall, inflation remains below our 2% longer run objective. And over the next few months, 12 months measures of inflation will move up as the very low readings from March and April of the last year fall out of the calculation. He expected some higher inflation in the following year, but not much. He shared the

The median inflation projection in that meeting in March 2021 of what the FOMC participants thought inflation would be over the next year. So in 2021, they assumed inflation would come in at 2.4%. It would be 2% in 2022 and then rise a little bit in 2023. So the two-year inflation expectation was only 4.5%. Actual inflation has been 14%. That's a huge miss.

Powell also mentioned that in the meeting, the committee in their policy statement, they said inflation was running below their 2% target. So they would allow inflation to rise above the 2% target before they would make changes in their policy rate. They said, we expect to maintain an accommodative stance of monetary policy until these employment and inflation outcomes are achieved.

They weren't going to raise rates until they saw inflation. And boy, did they ever. It took them an entire year. The first policy rate increase was in March 2022. By then, the annual inflation rate was 8.5%, six percentage points more than what the FMOC projected.

Now, it's been a year since the Federal Reserve has been raising their policy rate. It has been the fastest and steepest policy rate increase ever. It went from zero to 4.83%.

Back in March 2021, right after that press conference by Chair Powell, we released episode 333, Own Real Things. We pointed out some of what was going on with inflation. There was an increased money supply. It was up 20%, $4 trillion of new cash in the system. It was a combination from federal stimulus and quantification.

quantitative easing by central banks, purchasing bonds, big increase in money supply, but it wasn't showing up in the actual inflation numbers yet or in expectations. But we pointed out how this story can change. People start to worry about inflation. They would act differently, perhaps start hoarding, demanding higher wages, buying physical things that could push up prices. But I didn't think we'd get the level of high inflation that we saw.

In May 2021, interest rates had risen. We started to see a little higher inflation levels. I said, we will see rising inflation, higher inflation levels, more than we have seen in a number of years. Coming from a high demand for goods and services, pent-up demand, capacity constraints, the classic things that cause inflation in combination with a huge jump in the money supply. But I also thought it would eventually stabilize at 2% to 3%, and I still think that.

I said, I don't think we're going to get a sustained period of high inflation, but we might. And because we might, we should have some assets that can protect against inflation. And that's what we discussed in those two episodes. And that's what we want to share today. How did they do? Some did very well. Others did poorly, to be honest.

The most direct way to protect against inflation are assets whose returns are tied to inflation, but whose prices don't fluctuate. The best asset I know that fits that category are Series I savings bonds.

Series I savings bonds are issued by the U.S. Treasury. You buy them on the Treasury Direct website and they pay an interest. And the interest is what's known as a composite rate. It's a combination of the fixed rate component and the rate of inflation. And there's a new rate every six months. The Treasury will be announcing the new composite rate at the beginning of May. And had you bought a Series I savings bond back in March 2021, it kept up with inflation.

The base rate or the fixed rate of that composite rate was only zero. So we didn't exceed inflation by investing in Series I savings bonds, but it did fine. Now, the current fixed rate is 0.4%. So you get inflation plus 0.4% for new bonds purchased after May 2023. That fixed rate should be even higher. And so we'll be able to actually outpace inflation with Series I savings bonds.

But one of the challenges is you can only invest $10,000 per year per Social Security number. You're not going to get a couple hundred thousand dollars invested in this in one year. But over time, $10,000 here, $10,000 there, family members, that can start to accumulate. Another way to protect against inflation that we discussed in those episodes is Treasury Inflation Protection Securities.

These are inflation index bonds where the principal value is adjusted by the rate of inflation. But unlike Series I savings bonds whose prices don't fluctuate, TIPS prices can, as interest rates increase or decrease.

Many investors back in March 2021 were purchasing TIPS mutual funds and ETFs, thinking they would be protected against inflation. They didn't really understand how these vehicles work and that there's actually what's known as a real yield, which is the yield to maturity that the investors

the tips is priced at, and that the investor will get inflation plus that real yield to maturity. And the real yield to maturity was negative, over negative 1.6%, which means investing in tips, even if interest rates had stayed the same, that investor would have earned inflation minus 1.6%. And if interest rates went up like they did, then the price of tips could fall. And

And they fell significantly because that real yield to maturity went from negative 1.6% to over 1% today. Inflation came in high and holders of tips got that inflation adjustment, but the price fell because interest rates rose.

If we look at the iShares Tips Bond ETF, it's returned negative 2.6% total or cumulative over the past two years. The Vanguard Short-Term Inflation Protection Securities ETF, VTIP, returned 3.5% cumulative over the past two years.

The ETFs didn't keep up with inflation because prices fell as interest rates rose. Now, had you bought an individual treasury inflation protection security, one that matured in two years, you would have done much better. You would have kept pace with inflation because you would have gotten that adjusted principal value at the end and you would have made out very well.

That's why I prefer to purchase tips by buying individual bonds, either through Treasury Direct or through a brokerage, because you can lock in that inflation protection. Now, it doesn't mean that the bond won't fall in price, but if you hold it to maturity, you will get either the higher of the face value of the bond or the adjusted principal value that's adjusted by the rate of inflation.

I've been adding tips. I added one in February and one last fall because the real yield is 1.3 or 1.6% when I bought the one. And so that's attractive. It's higher than the yield on Series I savings bonds.

Sometimes Series I savings bonds are the better deal, like they were back in March 2021. And sometimes tips are the better deal, like they are today. But it depends. I mean, don't do Series I savings bonds. We'll see what the new rate is for Series I savings bonds that will be announced on May 1st, and then we can decide.

What has been the best inflation hedge over the past two years? Commodity futures. Commodity futures are contracts to deliver or take delivery of a specific commodity on a specific date in the future. In practice, though, most participants in the commodity futures market will reverse the position. They'll sell it so they don't actually have to deliver or take delivery of the physical commodity.

There are ETFs that invest in commodity futures like the Invesco DB Commodity Index Tracking Fund. It has 12% of its assets in gasoline futures, another 25 or so in the WTI and Brent crude contracts, 10% in gold futures, 8% in sugar futures and other agriculture and industrial metals. So it's just rolling over futures contracts.

The thing about commodity futures is you don't make money unless the price of the commodity exceeds what was reflected in the futures contract when you purchased it.

If you think oil will go to $110 a barrel, but the market thinks oil will go to $110 a barrel six months from now and the price right now is $80, then you won't make money unless oil goes above $110, like $120 or $130. And that's where it gets challenging. But that's when commodity futures shine, when inflation is higher than expected, pushing up commodity prices, and they do better than expected.

And that's what happened. The Invesco DB Commodity Index Tracking Fund, DBC, has returned 41% cumulative over the past two years. But in the past year, it's actually lost 13%. So all of the positive return occurred from March 2021 through March 2022, when inflation came in at 8.5%, much higher than expectations. Before we continue, let me pause and share some words from this week's sponsors.

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So commodities have done well. Now, another way to play commodities is just to own gold. And that's how I've chosen to get that exposure. I own gold coins. I've owned gold ETFs. If we look at the iShares Gold Trust, ticker is IAU, it's returned 13.5% cumulative over the past two years. So it just lagged the 14% inflation rate.

I think that's a win. It's done pretty well. But most of that occurred this year, and that's challenging with some of these inflation hedges. It's not like they go up every month as inflation rises, the exception being Series I savings bonds. They may not protect against inflation over shorter-term periods, even though they could do it over a 5- to 10-year period.

Stocks are an example of that. They, over the long term, have outpaced inflation. But stocks don't do as well when inflation is higher than its five-year average. In those scenarios, stocks have actually lost money, and that's what we've seen the past two years. We've had inflation higher than the five-year average, and the stock market has been down over the past two years.

The Vanguard Total World Stock ETF has returned negative 2.5% cumulative over the past two years. U.S. stocks, as measured by the Vanguard Total Stock Market ETF, VTI, have returned 0.5%, so slightly positive.

Now, when inflation is less than the five-year average, that's when stocks have done well. They've returned close to 14% per year. So stocks, it's a longer-term inflation hedge, not so good shorter-term with unexpected inflation, and that's what we've seen. But there are a type of stocks that we discussed in those spring 2021 episodes that have done well during periods of high inflation, and those are dividend-paying stocks.

Studies have shown that dividends tend to rise higher than the rate of inflation over time. And if we look at how dividend-paying stocks do relative to non-dividend-paying stocks, a study by Ned Davis Research that goes from 1973 through the first quarter of 2023, they show that all S&P 500 stocks, so the S&P 500,

a measure of U.S. large company stocks have returned 7.7% per year. That compares to all dividend-paying stocks, which have returned 9.1% per year, whereas non-dividend payers have returned 4.1%. So non-dividend-paying stocks have trailed the overall market and definitely trailed dividend-paying stocks. Dividend-paying stocks have done the best.

Now, the worst stocks are dividend payers that cut the dividend or eliminate them. They return negative 0.6% annualized. Now, there's no ETF for dividend cutting stocks. There are dividend payers. There are ETFs that invest in dividend growers. So dividend paying companies that are increasing their dividend, they've done the best, 10.2% per year.

But there is a benefit to owning dividend-paying stocks because you get the cash flow, the cash flow can grow, and they have outperformed non-dividend-paying stocks where all the return has to come through the capital appreciation because there isn't any dividend. So if we look at how dividend-paying stocks have done protecting against inflation, they've done pretty well. The Wisdom Tree U.S. High Dividend Fund ETF has returned 15.5% cumulative over the past two years, outpacing inflation.

If we look at dividend-paying global stocks that includes U.S. and non-U.S., the WisdomTree Global High Dividend Fund, it's only returned 7.6%. And we've discussed how non-U.S. has trailed the U.S. the past few years because the dollar has strengthened. And so having non-dollar currencies weakening has hurt the returns of international stocks. Conclusion is dividend-paying stocks have actually done pretty well protecting against inflation.

Another really good inflation protector is a specific ETF. It's the Horizons Kinetic Inflation Beneficiaries ETF. INFL is the ticker. It returned 14.6% cumulative over the past two years, outpacing inflation.

We first introduced this ETF in PLUS episode 334 in March 2021. This went out to members of Money for the Rest of Us PLUS. We shared it with everybody in episode 342 of the podcast in May 2021. Horizon Kinetics' approach is to own stocks of companies that are profitable, well-managed, but that don't need inflation to be successful, but do benefit from higher inflation.

An example would be a royalty company or a land trust that owns land and has mineral rights. And maybe they have outside companies producing oil on their property and they get the royalties. They're not actually doing it themselves. Those have done well. They have other companies like that in their portfolio. There's 48 holdings and it's done better than inflation. But it is concentrated and I haven't owned it. I wish I had, but we talked about it and it's done well.

What about real estate? We did talk about real estate, and it hasn't done very well over the past two years. The Schwab U.S. REIT ETF, ticker SCHH, negative 2.4% cumulative over the past two years. Real estate is tricky. Over the long term, real estate owners are able to raise their rent to keep pace with inflation, and that leads the property value to keep pace with inflation, hopefully exceed it. But over the short term, as inflation

interest rates go up, real estate holders, some have to refinance their properties at higher interest rates. So their cash flows drop. They're not necessarily able to raise their rent as much. And just the fact that you can now get 4.5% on cash. Some of these recent real estate projects were priced at a 4.5% yield or lower, what's known as the cap rate.

The cash flow, net of fees and expenses divided by the price of the property. And so when risk-free investments are yielding as much as real estate, that puts some downward pressure on REITs.

They did great in 2021, returning over 30% outpacing inflation, but then they fell 30% or more in 2022. And so REITs have struggled. Private real estate potentially, depending on the property, may or may not have outpaced inflation. We've talked about how appraisals are coming in. They're being marked lower because of the higher interest rates. But I still think real estate is a great long-term inflation hedge and pockets have been, but not every year. And

They can struggle when interest rates are increasing like we've seen. The worst performer of all of the various asset classes that we discussed. We've discussed TIPS, Series I Savings Bonds, Commodities, Gold, Dividend Paying Stocks, other stocks. But this one we would have hoped would have done better. It's the Quadratic Interest Rate Volatility and Inflation Hedge ETF. Ticker is IVOL. This

This invests in TIPS. So 80% of the assets are in the Schwab U.S. TIPS ETF, ticker SCHP. Now, we talked about how TIPS ETF struggled as interest rates rose. So that TIPS ETF returned negative 2.4%. But Ivol, this ETF actually lost 14% cumulative over the past two years. How did it do that?

Well, it uses an option strategy that benefited from the differential, the yield differential, the difference in what 10-year treasury bonds are yielding, the interest rate, and 2-year treasury bonds, what they're yielding. And the idea is they've structured an option strategy that if that spread widened, so interest rates would go up higher for 10 years than the increase in 2 years, then the ETF would benefit.

The exact opposite happened. The spread actually narrowed. In fact, two years ago, the 10-year treasury yield was 1.74%. Two-year treasury bonds were yielding 0.2%. So that difference, that spread was around 1.6%. Now the spread's negative. Two-year treasury bonds are yielding more than 10 years. The two years at 4.1%, the 10 years at 3.5%. And so that option strategy lost a boatload of money. It didn't go the way that the ETF was structured.

We had high inflation, but longer-term interest rates did not go up more than shorter-term interest rates because the Federal Reserve has been raising rates so aggressively because they got behind the curve.

I found it humorous that the way that Quadratic responded to this as a business is to launch a new ETF, the Quadratic Deflation ETF, ticker is BNDD. It's taking the opposite strategy. It's buying longer term bonds and then its option strategy is set up to benefit from a narrowing of those spreads or a flattening of the yield curve so that the 10-year and the two-year that spread narrows.

I can't recommend it. It's too complex. And the reality is we had rising inflation, we had high inflation, and Ivol didn't work. Partly it was having the tips, but the option strategy didn't even work. So I'm not convinced taking the opposite side would work any better.

I think we should protect against inflation in the simplest way that we can. We can own Series I savings bonds like I do. We can own Treasury Inflation Protection Securities, individual tips that we hold to maturity. It's not that hard to buy them. You can buy them when they're at auction and it can be done. There are less direct ways to hedge against inflation. Gold is

is one way to do it. Real estate, we've discussed. I own REITs, dividend paying stocks. I own them. We have them in our model portfolio examples. Commodities, it's a little more challenging. It's done the best, but not in the past year because of just the structure of commodities. I've

would love to be able to purchase copper, oil, commodities, if there was a way to do it where you were insured to benefit from the increase in commodity prices. They didn't have to do better than the consensus, what everyone already expects. And that's why I have some hesitancy with commodities.

I've already expressed some concern regarding IVOL, that particular ETF. INFL, the Horizon Kinetics Inflation Beneficiaries ETF, INFL, that would have been a good play. Did well. It did what it was supposed to. But again, it's not direct like owning a Series I savings bond, but it is a way to basically participate in the equity market and holdings that could benefit from ongoing inflation.

Are we going to continue to have high inflation? Well, we don't know. Just like we didn't know two years ago that it would come in as high as it has. Good news is the annual U.S. inflation rate, as measured by the Consumer Price Index, fell to 5% its lowest annual increase since April 2021. And that was the U.S. inflation report that came out a few weeks ago.

For the month, inflation fell 0.1% because energy prices fell and food at home prices fell. But if we look at core inflation, stripping out energy, stripping out food,

Its annual rate actually increased. There are elements of inflation that have been sticky. The housing component has been sticky. The services component has been sticky. It's not dropping as quickly as the Federal Reserve would like or we would like. And so it's quite possible that the Federal Reserve will again raise its policy rate at its May meeting, taking it over 5%.

Hopefully, the overall inflation rate will come down. There are signs that inflation is moderating, what's known as disinflation. Still have a higher inflation, but not as high as it was in previous periods. So there's not falling prices. It's just that the annual inflation rate isn't as high. It could be over 3% for some time. And so continuing to have some inflation protection makes sense. Well, it always makes sense because we don't know what's going to happen. We want to protect against it.

There are strategies that do very well. Some didn't do so well. Some aren't direct tick-by-tick protection like Series I savings bonds, but have done well over the longer term. That's episode 429. Thanks for listening.

I have thoroughly enjoyed teaching you about investing on this podcast for almost nine years now. But some topics are just better explained in writing or with the chart. That's why we have a weekly email newsletter, the Insider's Guide. In that newsletter, I share charts, graphs, and other materials that can help you better understand investing. It's some of the most important writing I do each week.

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