Inflation protection is all about future consumption

A guest post from Haydn at Perpetual Prudence on how generic inflation protection doesn’t work and shouldn’t be used. What you really need is protection against future consumption.

Inflation

Most people think about inflation in the wrong way

They see the headline numbers (“The CPI has risen by 5%!”) and worry about the implications for their purchasing power and their real rate of return of any investments they have made (real, as in adjusted for inflation).

This seems sensible – if price levels have risen, the same R200 cannot buy the same stuff that it used to be able to. This is why whenever you think about returns, or money in general for that matter, you must think about real returns. Any growth in wages/prices/anything must be thought about in this way: discounted for inflation.

But there is a catch. The reported level of inflation is the changes in prices on an aggregate level.

How is inflation calculated?

Inflation is calculated as an average across a basket of goods. This is a pre-selected list of all sorts of items that you may, or may not, consume.

If the economy is composed of three goods A, B, and C and inflation is 5% this means that the value of the sum A + B + C = D has increased by 5%. This does not tell us anything about the prices of the constituents of D. If C makes up 50% of D and rises by 20%, A and B can decrease in price and there would still be positive inflation overall. May sound confusing but really, some things go up in price, and some decrease. Inflation is simply the average based on a selected list of items that are tracked.

There is also the problem of which aggregate price level indicator to use. The choice of CPI is somewhat arbitrary. Inflation in South Africa could just as easily be measured by some other number. RPI, which takes housing costs into account, has been used in other countries. You could also use “Core inflation”, which removes highly volatile goods from the collection that the index is based on.

Ultimately, though, these measures are all plagued by the same problem: they include many things that you will not consume and therefore should not be concerned with the price of. Why should I care about the price of C if I don’t consume C? Should I be worried about inflation because CPI has increased by 5% but I only consume A and B which have decreased in price? This seems silly.

Take RPI vs. CPI above as an example. If RPI is used as the inflation measure but I don’t own a house, the costs associated with housing (that I don’t care about) are going to be included when, in reality, I don’t care about these costs.

Why should I care if car prices are rising if I don’t intend to buy a car? And why care if meat prices are sky-rocketing due to supply issues and droughts if I’m a vegan (I’m not, just to make that very clear)? Why do I care about rising alcohol prices if I don’t drink (again, I’m not in this category)?

You don’t. You shouldn’t. This is why CPI is an overly-simplistic measure. This is also why some feel like their personal inflation rate is significantly higher / lower than the generic measure. Because it probably is.

General Inflation Hedges

If you miss-identify the problem, the solution probably isn’t going to be correct.

Many, rightly worried about inflation, try to hedge against rising price levels using their portfolio. According to investopedia, an inflation hedge can be defined as “an investment that is considered to protect the decreased purchasing power of a currency that results from the loss of its value due to rising prices either macro-economically or due to inflation.”

You often hear discussions of the “best inflation hedges”, with the following assets often considered to be best options for this purpose:

• Inflation-linked bonds. The South African government started issuing inflation-linked bonds in 2000. These bonds are loans for which the principal and interest payments are contractually linked to inflation. They work by increasing the principal value of the bond in-line with inflation. As this value increases, the interest payments (which are in a fixed %) also increase (in rand value). Happy days.
• Commodities. When I was at school we were told that “oil is in everything”. Hence, as the price of oil rises, so does the price of everything else. So oil could be used as a proxy for/to predict inflation. The same logic is extended to other commodities: these goods are vital base components of the economy, so increases in their prices reverberate throughout the economy. Hence, owning commodities protects you against inflation because increasing prices lead to both your portfolio increasing in value and higher prices in general throughout the economy.
• Equities. If you own shares you own a part of a company. Hence, if the profits of this company increase, they are more likely to both increase the dividend they pay to their investors (you) and their share price is also likely to rise (increasing your portfolio value). Imagine if you owned all the biggest companies in South Africa by, I don’t know, holding an index fund maybe. If prices are increasing generally, these companies are likely to be generating more revenue. If costs don’t rise by as much, this will lead to higher profit. This may increase the value of these companies and, hence, the value of your portfolio.
• REITs. REITs (Real Estate Investment Trusts) own and operate (usually commercial) real estate. If prices rise, companies make more profit, they can afford higher rents, rents increase, property values increase, REITs make more money. That’s the theory, anyway.

Many would add collectable-type assets like gold, art, wine, bitcoin, watches, etc. I do not consider these inflation hedges. There is no logical reason as to why the price of these assets would rise as prices in general are rising, other than the argument that can be applied to literally everything (as prices rise, companies earn more, pay their employees more, employees increase consumption of goods and services, goods and services rise in price).

These assets have mixed records when it comes to acting as an inflation hedge. In fact, it’s very hard to implement a passive investment strategy that effectively hedges against general inflation in all financial climates

Specific Inflation Hedges

What an inflation hedge should be is a hedge against your future consumption. As the price of your prefered goods and services rise, so too should the assets you own to protect yourself against such a rise.

For Corporations

If you’re a farmer growing maize, you plant your crop and wait a few months for it to grow. At that point you sell your goods for, hopefully, a profit. However, there is a problem. There is a time gap between your costs and your revenue. It’s hard to tell if you’re going to make a profit because, due to the fluctuating price of maize, you don’t know how much your produce is going to be worth when you go to sell it.

Futures contracts were born out of the desire for farmers to protect themselves against this phenomenon. They enabled them to agree a price today at which they could sell their produce when it was ready, thus being sure about expected profit.

This is sort of like what a specific inflation hedge should be: protection against rising (or in this case falling) prices of a certain good or collection of goods.

These specific financial contracts can and do act as specific hedges.

When multinational corporations want to protect themselves against currency fluctuations they purchase (hire Goldman Sachs to purchase) financial instruments that are constructed in such a way to hedge against specific movements in the currency markets. Many hedge funds (clue in the name) also use these types of techniques, often to protect themselves against general movements in markets in order to isolate one specific asset or group of assets.

For Individuals

Unfortunately, actually probably fortunately, you are not a corporation. This means that you will not have access nor ability to employ these advanced financial techniques.

Hedging against future consumption is difficult. You can’t really purchase mountains of food, beer, petrol, etc. with the hopes of selling it later if prices rise.

All hope is not lost, though. There are still some things you can do that can be effective. It all depends on your future consumption…

Going to buy a house? Probably want some exposure to the housing market in the form of a REIT or some other instrument. As house prices rise in general, the value of this REIT should rise too, hence you are more indifferent to rising house prices.

Retiring in Europe? Probably want to accumulate some euros. If the rand becomes significantly devalued relative to the euro over the next 10 years, retirement may become relatively more expensive as the same amount of rand buys fewer euros, whilst the price of goods and services in Europe (priced in euros) remains the same. Purchasing euros now prevents this phenomenon.

Fly a lot? Maybe you should own some oil as fuel costs are a major component of airline expenses. Granted, there are many others things that go into determining the price of airline flights, most of which are difficult to hedge against. However, as the price of fuel rises, airlines will be more likely to increase their prices. If you own this fuel, you won’t care as much because the value of your portfolio is increasing, too.

Drink a lot of Coke? It might be a good idea to own Coca Cola shares. If they increase the price of Coke, Coca Cola may take in more revenue. If costs stay constant, this means more profit, which typically leads to higher share prices.

Doing these things is by no means a full-proof strategy. Some are even pretty tenuous. This is a relatively unknown concept and the financial infrastructure for those wishing to protect themselves against specific inflation doesn’t really exist. Currently, specific inflation hedges are hard for retail investors to find and use. I eat a lot of blueberries, for example, so I would love to own an asset that rises with the price of blueberries to protect me from rising blueberry prices. This sadly doesn’t exist.

The main thing I want to emphasise is the thinking behind such approaches. Passive investments to hedge against general inflation don’t work very well, but that doesn’t really matter. What you should care about is hedging against your future consumption, not general price levels. This is the real way to hedge against inflation.