Investing in an Inflated Economy
Why Invest in Alternative Investments
Inflation: Why is it Happening?
Data shows that, in addition to the highest annual inflation rate in 13 years, there has been an 8.6% annual increase in producer prices, a metric measured by the producer price index (PPI). Producer prices commonly increase in response to inflation, as a means by which businesses attempt to recoup losses. Both CPI and PPI data are published by the Bureau of Labor Statistics.
These increases are reasonable and expected in the wake of the COVID-19 pandemic, which effectively halted the global economy for months. Although many factors contribute to the current rise in inflation, including efforts to improve pandemic conditions, evidence suggests that current market inflation is primarily driven by the following factors:
- Labor shortages. A shortage of workers can put pressure on businesses to raise wages in an effort to attract new staff. Some businesses recoup labor costs by raising their prices, which subsequently raises PPI.
- Disrupted supply chain. Supply chain issues, such as product shortages and halted production or transit lines, contribute to a limited supply, which drives up demand. Increased demand drives up a product’s price, further fueling inflation.
- Pent-up demand. As more people receive COVID-19 vaccinations, businesses reopen, and federal aid supplements the economy, consumer spending continues to surge. Consumers are expressing sudden, high demand for services they forwent during the height of the pandemic, such as flying and staying in hotels.
- Rising energy prices. Surging energy prices driven by geopolitical forces, disrupted supply, and a reopening global economy may force business owners to raise prices to make up for money spent on energy-related costs. The market experienced rising commodity prices and raw materials prices overall, as a result of production cuts and unexpectedly high demand that increased the price of materials like lumber, steel, and copper.
Inflation affects industries across all sectors, but it has a pronounced, direct effect on the financial services industries. When it comes to investments, the effect depends on the type of investment in question.
How does inflation affect stocks and similar holdings?
Consider how the following types of investments fare during times of high inflation:
- Savings. Even if funds are secured in a savings account with an average interest rate, inflation can shrink the value of savings dramatically. When an individual is working, earnings should theoretically keep up with inflation; when individuals are forced to live off of savings, inflation diminishes purchasing power.
- Fixed income investments. When inflation rises, the purchasing power of interest payments declines. This is because the rate of interest stays the same on most fixed-income securities until maturity. As a result, bond prices tend to fall as inflation increases.
- Stock investments. Although some stocks hold up well against inflation, stock investments are negatively impacted in an inflated economy. According to long-term economic research, “Most of the empirical literature reports a negative relationship between inflation rates and stock returns in the post-1953 era.” Large U.S. stocks tend to decline in price alongside increased inflation.
- Alternative investments. Commodities and real estate investments have a positive relationship with inflation and tend to perform well in even highly inflated economies. Inflation is measured as the rising price of goods and services, which either directly contains commodities or are closely related to them.
Shareholders are not the only ones at risk for inflation-related investment losses; inflation can also indirectly affect people who do not actively invest. Retirees who depend on social security to supplement their income are vulnerable to rising inflation, as the trust funds for social security only invest in U.S. treasuries, which don’t keep up with inflation. In an effort to mitigate inflation’s impact on retirees, the federal government issued a 5.9% boost in benefits for 2022. While necessary, these boosts deplete an ever-dwindling reserve of funds.
What Does Inflation Mean for Real Estate?
REITs are a well-known, solid investment strategy in times of high inflation. However, that does not mean that the real estate market is impervious to inflation; the real estate market is impacted by dynamics that include labor and supply shortages, pent-up demand, and rising commodity prices.
Real estate is still a high-value investment choice for many reasons, which come into sharp relief during times when the economy is inflated:
- Real estate can provide dynamic cash flows. Income streams from real estate can rise over time, unlike investments with fixed cash flows. Short lease durations in high-growth sectors can yield higher market rents more quickly, increasing cash flows.
- Real estate income may provide an inflation hedge. Data from the Bureau of Labor Statistics indicates that real estate income has generally outperformed inflation since 1995.
- Value may increase alongside interest. Private real estate values have historically increased during periods of rising interest rates.
- Sector selection is critical. Long-term leases with limited rent resets may be more susceptible to the effects of rising inflation. Sectors like apartments and warehouses generally have shorter-duration leases, which may result in less impact to a commercial real estate professional.
The commercial sector presents an unrivaled investment opportunity. Office and retail properties create high-value profits, even in an inflated market.
Real Estate Investments Benchmarked: Why Invest in Alternative Investments
Alternative investments are generally defined by what they are not: stocks, bonds, and cash, all of which are considered traditional investments. More specifically, alternative investments generally fall into four primary categories: private equity, hedge funds, real estate, and commodities.
Each type of alternative investment has its own process, risks, and reward profile. However, most alternative investments are relatively illiquid, meaning they are not easily sold or converted to cash.
Some alternative investments have inflation hedging properties, such as appreciation potential, and the ability to generate cash flow and general noncorrelation to the stock market. Additionally, alternative investments can provide much need portfolio diversification, which mitigates vulnerability to widespread losses due to a singular economic event.
Real Estate Investments in an Inflated Economy
Inflation weakens purchasing power, causing the price of goods and services to increase. Investors who own real estate or invest in REITs may experience protection from inflation for the following reasons:
- Real assets carry intrinsic value
- Inflation increases property value
- Income from rent can grow with CPI
- Inflation depreciates mortgage debt
Leveraging the combination of returns by investing in real estate can reduce an investor’s overall portfolio volatility without sacrificing exposure to higher risk assets. A solid understanding of how market fundamentals and industry trends can affect investments will equip investors to create value.
The following graph illustrates how portfolios that include real estate investments fare in comparison to portfolios that do not.
Every year the Callan Institute publishes periodic tables that illustrate various investment returns over a 20-year period. The Callan Institute’s 2020 report includes a periodic table of annual alternative investments’ returns (compared to key public market indices), ranked in order of performance. It reveals the following trends:
- Investments with low correlation to financial markets and high correlation to geopolitical forces have yielded high returns and equally extreme losses.
- Investments with bond and stock allocations have yielded low, stable returns and have been among the most vulnerable investments to market uncertainty.
- Cash equivalent investments have averaged the lowest returns but have also yielded the highest return low over 20 years.
- Hedge fund returns, including real estate fund returns, have historically had a low correlation to inflation.
- S. fixed income investments and real estate fund investments have been the most consistently profitable investments.
These trends suggest that real estate investments, including indirect investments through REITs, yield consistent profits and few annual net losses. Real estate investments are resistant to inflation and can perform well in conditions of market uncertainty. Highly illiquid, real estate is an ideal sector for investors interested in stable, moderate year-over-year returns with potential for exponential growth in certain economic climates.