Inflation Schmination

Confused by Inflation?

Inflation matters. Every so often the market removes inflation from its radar screen, only for it to violently claim back its place atop the totem pole of market worries. Investors tend to be well acquainted with the benefits of diversification to dampen the effect on most market drivers. However, inflation is a risk that many consider difficult to diversify from.

This wide-ranging effect has both direct and indirect causes. Inflation directly pressures wages, reduces consumers’ purchasing power, and increases manufacturers’ inventory costs. It indirectly affects monetary and fiscal policy -- central banks hike rates, which affect equities with higher discount rates, hurting bonds by rising yields and forcing governments to cut spending, slowing GDP growth.

Nevertheless, inflation is a hard read, especially since there are several measures with different constituencies. The most visible – and politically influential – proxies for inflation are gasoline and grocery prices. Albeit non-conventional inflation metrics, they are published everywhere, atop 50ft poles, reminding everybody about the cost of living.

The most conventional inflation metrics are the changes in CPI (Consumer Price Index). CPI is published monthly by the Bureau of Labor Statistics (BLS), measuring the change in the cost of goods and services typically bought by urban consumers in 87 metro areas. It splits the index between “headline”, which includes everything, and “core”, which includes energy and food to smoothen volatility.

The Fed prefers the PCE (Personal Consumption Expenditures) to guide monetary policy, estimating that it has been a more robust indicator of price trends. The PCE targets people’s actual consumption patterns, rather than a fixed basked like the CPI.

Pro-Inflation, Anti-Inflation, Inflation-Neutral?

Inflationary trends are extremely hard to identify. The most educated, experienced, and smartest players in academia and finance are nearly always split midway between hawks and doves. Broadly speaking, the run-of-the-mill retail investor has about the same chance of predicting the trend as any well-placed economist in DC or Wall Street.

As with most situations we have presented in these series of Newsletters, investors can choose what side of the trade they want to be on. The following are examples of ETF's;

Expecting inflation to go up? Get the mighty dollar through the UUP ETF. This is one of the hardest trades as most asset classes are hurt by inflation. Historically, higher yields and risk reduction attracts investors to the US$ as it gains in high inflationary environments. The Invesco-managed UUP ETF ($2.3b assets under management) tracks the relative value of the US$ vs. a basket of foreign currencies.

Expecting inflation to go down? Long bonds (TLT) and tech (QQQ, IYW). The main effect of declining inflation is a drop in rates, which trickle into lower long-bond (20+ yrs.) yields; the TLT ETF ($25b AUM) tracks a basket of 20+ year treasury bonds. Lower rates disproportionally benefit stocks of growth companies with backloaded cash flows, which abound in the tech sector; the simplest way is to use the Nasdaq-tracking QQQ and US-tech IYW ETF’s ($150b and $8b AUM).

I don’t know what to do! TIP and STIP. Investors may feel unprepared to take a position on inflation. Treasury Inflation Protected Securities (TIPS) adjust their principal value with inflation, so the real value of the investment remains unchanged. The TIP ($25b AUM) and STIP ($12b AUM) offer easy-to-execute exposure to long-term and short-term TIPS.

Investors should consider an ETF investment objective, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other important information, is available from Lime Trading to https://lime.co/disclosure-statements/ and should be read carefully before investing.

What could go wrong with this type of strategy?

Trying to get on the right side of inflation is extremely difficult. Inflation estimates are fallible in the short term and uncertain to a fault in the long run. Investors who want to get directional exposure to inflation should carefully consider the high degree of unpredictability of price trends.

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