“By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”
-John Maynard Keynes, The Economic Consequences of the Peace, 1919
There has been a lot of ink spilled about the amount of government debt outstanding, a number that has recently exceeded $38 trillion. More importantly, this debt should be measured against GDP, a measure of income. But even still, the ratio has increased over time with big step ups due to the global financial crisis and COVID-19 pandemic. As recently as 2000, the ratio was under 60% of GDP. The ratio now sits at about 120% of GDP.
The most likely way out of this predicament in the long run: inflation, which reduces the purchasing power of the dollar through the printing of money and makes it easier to repay debts. From the early 1990s to 2020, inflation was very well behaved, generally very close to the Federal Reserve’s target rate of 2%. However, since then, inflation has been more of a concern, spiking to a 9% rate in mid-2022 and averaging closer to 3% more recently.
The difference between 2% and 3% may not sound like a lot, but if long-term interest rates do not reflect an accurate view of inflation, investors may not be adequately compensated in real terms. In that case, the quote from celebrated economist Keynes highlights a real concern. Inflation is clearly an investment risk we need to consider as we manage client portfolios.
As investment managers, what tools do we have to manage inflation risk? A few come to mind: precious metals, TIPS, energy stocks, stocks of quality companies, real estate and (perhaps) Bitcoin are prime candidates. Each has its pros and cons, which we will touch on briefly below.
- First, precious metals. Over very long periods of time, precious metals (gold, silver, platinum) have held their value in terms of purchasing power. There is a famous saying that an ounce of gold can buy a good suit. That has generally held through long periods of time. However, in the short term, there could be significant variations between precious metals and inflation. For example, from 1980 to 2007, gold went nowhere. However, from 2018 to 2025, gold has wildly outperformed inflation. Precious metals may provide a good long-term hedge, but not necessarily a great short-term hedge against inflation.
- Treasury inflation-protected securities (TIPS) are Federal government bonds that pay a lower (real) rate than “regular” bonds. However, the principal is indexed to inflation as measured by CPI. For example, if you purchase $10,000 worth of TIPS and CPI inflation runs at 10% for the year, the principal value of the TIPS you purchased would be $11,000 at the end of the year. This gives the investor a direct hedge against inflation as measured by CPI. The weakness here is that the government controls the computation of CPI. There have been numerous changes to the methodology over the years.
- Energy stocks provide a reasonable hedge against inflation. It is difficult to imagine an inflationary period where crude oil and natural gas prices do not also move higher. Historically, the relationship holds during inflationary periods; energy stocks were some of the best performers in the inflationary 1970s, and the energy sector was the best performer by far in 2022.
- Quality stocks are also a reasonable long-term hedge against inflation. In the long run, stocks of quality companies should be able to pass along inflationary cost increases to maintain or even expand margins. The short run could be painful, however. As inflation rates begin to rise, and interest rates follow, multiples are likely to compress as we saw in 2022.
- Real estate has also traditionally provided a good inflation hedge over the long term. A critical variable here is the length of the leases on the property. If the property is saddled with long-term fixed-rate leases, the property likely will not provide a great hedge against inflation until those leases roll off.
- The new kid on the block is bitcoin. There is not enough history to be confident either way here. However, in theory, due to the constraint on bitcoin supply, it should provide a nice long-term hedge against inflation.
These are all options in our toolbox as we manage client portfolios, considering each individual’s goals and risk tolerances. Be sure to discuss any changes to your goals or lifestyle with your advisor at least annually, so we can fine-tune our toolbox for your situation.