Inflation can be a good or bad thing depending on your perspective. However, knowing how to profit from inflation is a great way to protect your money and even increase your wealth.
What is Inflation?
Inflation occurs when goods and services rise, making them more expensive relative to the amount of money you make.
There are several definitions of inflation, but most surround a basket of goods and services that are used every day.
Economists will often remove food and energy from their inflation calculations, to smooth the volatility. The factors that generally drive inflation are rent equivalents, which are the costs to own or rent a home, as well as, labor costs.
When inflation begins to rise, which can be measured using the Consumer Price Index or the Federal Reserves’ favorite gauge the Personal Consumption Expenditures, certain assets will generally outperform.
These assets include specific commodities, certain stock sectors as well as inflation-protected bonds.
How Do You Measure Inflation?
When your landlord asks to raise your rent or the price of food at the supermarket begins to rise, you are experiencing inflation.
Economists measure inflation by looking at a basket of goods and services that are used by individuals during their daily lives.
Inflation becomes an issue when the consumer needs to pay more for goods and services beyond what they can afford. The two most common gauges of consumer inflation are the Consumer Price Index and the Personal Consumptions Expenditures index.
Inflation is usually measured month over month as well as year over year.
The Federal Reserve has a guide they use which is to keep inflation near 2% year over year. When it begins to grow beyond this level, the Fed will try to reduce this acceleration by increasing interest rates.
The reverse is also true.
When inflation is falling at a rate below 2%, the Fed will reduce interest rates to spur on inflation.
Why Does Inflation Occur?
Several factors help buoy inflation. When demand begins to rise at a rate that is greater than the supply, prices will be forced higher.
For example, during the COVID-19 crisis, people living in cities were looking to exit and quickly move to the suburbs which drove the price of homes in the suburbs higher.
Additionally, the increase in the cost of production due to higher labor costs or the increase in the price of a commodity with make homes more expensive.
The two most prominent drivers of inflation are wage inflation as well as rent equivalents which are the cost of owning or renting a dwelling.
How to Profit from Inflation – Assets that Outperform
When inflation begins to rise, certain assets historically have outperformed. The assets that outperform include:
- Commodities
- Real Estate
- Inflation-Protected Securities
- Late Cycle Stocks
Commodities are assets where the price is commoditized. This generally means that the price in one location is the same in all locations minus transportation.
The most prominent commodity tied to inflation is gold. Gold has a long history of trading higher when inflation expectations rise.
Investors believe that as inflation increases, the value of paper assets, such as bonds or even the dollar will lose value, while hard assets such as gold will gain in value.
Like gold, as prices rise, so does the price of oil, as the demand for transportation fuel increases. This flows through to gasoline which helps further buoy inflation.
As inflation increases and wages climb the demand for food will also rise, driving up commodities such as corn and soybeans.
How Do You Purchase Commodities?
To take advantage of potentially higher commodity prices, you can purchase these assets. Gold and silver can be purchased physically. You can also purchase gold, silver, oil, gasoline soybeans, and corn using futures contracts.
These contracts are the obligation to purchase a commodity at a date in the future on a regulated exchange.
Additionally, most commodities can be purchased using an Exchange Traded Fund (ETF). Commodity ETFs like GLD (SPDR Gold Shares), USO (United States Oil Fund), or CORN (Teucrium Corn Fund) can provide investors with a stock-like product that tracks the movement of a commodity.
Real Estate Also Outperform During Rising Inflationary Periods
As inflation begins to rise, rent equivalents trend higher making real estate an attractive asset. Real estate is a finite asset, and it’s difficult to produce more.
As wages rise, the demand for dwelling also increases, pushing up the value of Real Estate
You can purchase real estate, in many ways. You can buy a primary or secondary home. You can purchase rental properties.
You can also purchase real estate investment trusts which are stock-like funds that benefit from rental payments and the increasing value of the properties.
Purchasing Inflation-Protected Securities (TIPS)
When inflation begins to accelerate, securities that rise in value such as TIPS can outperform. TIPS are treasury protected securities which are bonds that rise in value as inflation rises.
TIPS Inflation Index Ratios calculate the change to principal resulting from changes in the Consumer Price Index.
As inflation rises the value of the security rises.
This compares to regular treasury bonds, where the value generally declines because fixed payments received from bond coupon payments are eroded by the increase in inflation.
Late Cycle Stocks
A business cycle goes through several stages.
The cycle includes:
- Early Cycle
- Mid-cycle (Inflation starts)
- Late Cycle (Inflation accelerates)
- Recession
During the late cycle, inflation starts to accelerate, and certain stock sectors will begin to outperform. This includes the energy sector and the materials sector.
Usually, as the price of oil rises, the companies that produce energy follow.
Additionally, as commodities rise, the companies that produce these commodities in the materials space move higher in tandem.
Bottom Line
The upshot is that there are several ways to invest in assets that will outperform during inflationary periods.
Inflation occurs when prices begin to rise measured by a basket of goods and services. The most popular inflation targets are the Consumer Price Index (CPI) and the Personal Consumption Expenditures index.
The Federal Reserve’s target inflation level is 2%. Generally, inflation is buoyed by increases in wages and rent equivalents.
The most popular assets include commodities, real estate, inflation-protected bonds, and late-cycle stocks.
Many of the stock sectors that outperform during inflationary periods are commodity-related companies.