Inflation Protection

Telemus Weekly Market Review October 3rd - October 7th, 2022

This coming week the Bureau of Labor Statistics will report the Consumer Price Index (CPI), for the month of September. The CPI is the common barometer for U.S. inflation. The Cleveland branch of the Federal Reserve has built a tool where it attempts to provide a real time estimate of monthly CPI readings. As of week’s end, the Cleveland Fed’s Inflation Nowcasting tool projects inflation of 0.3% for the month of September, which would lead to an annualized inflation rate of 8.2%. What we view as a more pertinent reading is Core CPI, which excludes the more volatile food and energy categories. The Cleveland Fed is currently projecting Core CPI of 0.5% for September, which would still be considered an elevated level.

This past week markets continued to grapple with expectations around inflation and how the Fed would react. At the start of the week, stocks shot higher, rising a cumulative 5.7% on Monday and Tuesday. At the same time, interest rates dropped. This was all fueled by speculation that the Fed might pivot on its higher interest rate stance sooner than later. That optimism around higher rates quickly faded. Multiple members of the Fed’s rate setting body, the Federal Open Market Committee, spoke publicly and reinforced that not only are they committed to fighting inflation with higher rates in the near-term, but that they expect to maintain the higher level of interest rates for some time just to ensure they’ve effectively put out the inflationary fire.

Over the last few years, we’ve been proactively researching how to incorporate inflation protection into our client’s portfolios. Its not an easy problem to solve, as often the optimal solution is dependent on the magnitude of inflation as well as what is occurring with other economic indicators such as interest rates and the value of the dollar. Thus, there is no simple, straight forward playbook for how to protect your current and future purchasing power against inflation.

One mechanism to achieve some inflationary protection is the purchase of Treasury Inflation Protected Securities, or more frequently referred to as TIPS. TIPS are Treasury bonds whose coupon, or semi-annual interest payments, adjusts with the rate of inflation. Therefore, after a year such as 2022, interest payments received from TIPS are higher than where they were a year ago. The challenge with TIPS, is that up until recently they were overbought to the point where investors would have to accept a price offering a negative yield (on a real, inflation adjusted basis). Thus, while the coupon income was helpful, TIPS owners were paying a price that offered a negative inflation-adjusted total return just to have some protection against higher prices. In our view, TIPS are an effective inflation fighting tool to have, but its important to be conscious of the price that is paid for that inflation protection.

Real estate and infrastructure offer another solution. Infrastructure assets such as toll roads, pipelines and utilities are able to adjust prices quickly and therefore react to inflation on more of a real time basis. Alternatively, real estate has a similar construct, although the sector tends to lag inflation since rents are only reset when leases expire. Assets like apartments, where leases tend to be a year or less, are able to respond to inflation quicker than say an office building where leases may average five years in length. Since real estate investments tend to incorporate the use of debt financing, higher interest rates are to some degree acting as an offsetting headwind to the benefit of rising rents.

A third way to protect purchasing power against inflation is to own commodities. Commodities tend to react to current supply and demand conditions. Inflation stems from a lack of supply or excessive demand. Either would likely benefit commodity prices. Year-to-date, the Bloomberg Commodity index is up over 18% as commodity prices have positively reacted to inflationary conditions. An extension of commodities is natural resource equities. These are stocks of businesses that are involved in exploration, production and refining of commodities. They could include oil companies, such as ExxonMobil, or miners such as Freeport-McMoRan. The fact that these businesses can often hedge the value of the commodities they are producing enables them to extend their ability to profit from a commodity cycle by locking in current prices into future years. Visibility into these assets, however, is limited as commodity prices can move quickly. We saw that with the Bloomberg Commodity index, which was down over 8% in September, and this week alone rebounded by approximately 5%.

Inflation is likely to remain a hot topic. We do believe that over time the pace of inflation will come down, but it won’t be in a linear fashion. There will be fits and starts along the way. Having some inflation protection in your portfolio is a prudent consideration. However, navigating through the environment with the right type of protection is something we spend a lot of time thinking about and incorporating into our clients’ portfolios.

All opinions expressed in this article are for general informational purposes and constitute the judgment of the author(s) as of the date of the report. These opinions are subject to change without notice and are not intended to provide specific advice or recommendations for any individual or on any specific security. The material has been gathered from sources believed to be reliable, however Telemus Capital cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. PAST PERFORMANCE IS NOT A GUARANTEE OF FUTURE RESULTS. Investment decisions should always be made based on the client's specific financial needs, goals and objectives, time horizon and risk tolerance. Current and future portfolio holdings are subject to risk. Risks may include interest-rate risk, market risk, inflation risk, deflation risk, currency risk, reinvestment risk, business risk, liquidity risk, financial risk, and cybersecurity risk. These risks are more fully described in Telemus Capital's Firm Brochure (Part 2A of Form ADV), which is available upon request. Telemus Capital does not guarantee the results of any investments. Investment, insurance and annuity products are not FDIC insured, are not bank guaranteed, and may lose value. Any reference to an index is included for illustrative purposes only, as an index is not a security in which an investment can be made. Indices are unmanaged vehicles that serve as market indicators and do not account for the deduction of management fees and/or transaction costs generally associated with investable products. The S&P 500 index includes 500 leading companies in the US and is widely regarded as the best single gauge of large-cap US equities. The Bloomberg Commodity Index (BCOM) is calculated on an excess return basis and reflects commodity futures price movements. The index rebalances annually weighted 2/3 by trading volume and 1/3 by world production and weight-caps are applied at the commodity, sector and group level for diversification.

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