“Hyperinflation is going to change everything. It’s happening.” Twitter (NYSE:TWTR) co-founder Jack Dorsey issued this ominous warning two weeks ago, by tweeting it of course.
Taking the other side of that trade is Federal Reserve Chairman, Jerome Powell, who says that inflation will be “transitory.”
As he explained recently:
“The current inflation spike is really a consequence of supply constraints meeting very strong demand, and that is all associated with the reopening of the economy, which is a process that will have a beginning, a middle and an end… We see those things resolving.”
Obviously, either Dorsey or Powell will be wrong.
But I suspect Dorsey’s forecast will be closer to the mark than Powell’s, which is why I believe it is worthwhile to consider adopting one or more hedges against an unexpected inflationary uptick.
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Hedging Method #1
One such hedge is the ProShares Short High Yield (NYSEARCA:SJB), an ETF that uses interest rate derivatives to bet that high-yield bond prices will fall (as interest rates rise).
A rising interest rate trend would cause the prices of almost all bonds to fall, but junk bond prices could drop even more severely than safer bonds like U.S. treasuries.
In other words, the “spread” between junk bond yields and Treasuries could widen, to the detriment of junk bond prices.
But treasury bonds certainly aren’t safe when inflation is rearing its head. And in case you missed it, the CPI inflation reading just hit 6.2% — a new 30-year high.
Long-dated treasury bond prices have been falling since the moment this announcement crossed the newswires, but this mini-selloff could be just the beginning of a major move lower, which would be very bad news for fixed-income investments.
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Prior to the CPI announcement this week, the 30-year Treasury bond was priced to yield 1.85% per year. But if rising inflation caused 30-year interest rates to rise to just 3.0% over the next 12 months, the value of that bond would drop about 25%. If yields continued rising to 4%, the 30-year bond price would tumble about 40%.
Because of unfavorable math like this, the legendary interest rate expert, Jim Grant, sometimes refers to low-yielding bonds as “return-free risk.”
This math also strongly suggests that investors should be avoiding long-dated bonds for now.
To be clear, our hypothetical 30-year bond-buyers would not book any actual losses if they held their bonds for the entire 30 years until maturity. From that standpoint, they would not “lose money.”
But for 30 years they would be wishing they had never purchased a long-term bond yielding 1.85% per year, when they could have received a much higher rate of interest instead.
Hedging Method #2
In addition to buying direct hedges against inflation like SJB, I would also suggest taking a look at select indirect hedges, like stocks in the natural resources sector that can benefit from factors like inflation, but that also offer investment merit in their own right.
Commodities and the companies that process them tend to perform well during periods of high inflation.
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The chart below tells the tale. It shows the average annual returns of gold and commodities, minus the average annual return of stocks, during various inflationary readings of the last 60 years.
The far-left bar in the chart, for example, shows that gold’s average annual return was 11% worse than the S&P 500’s annual return following CPI inflation readings below 1%.
But the bar on the far-right side of the chart shows that gold delivered an average annual return that was nearly 75% higher than the S&P 500’s when CPI readings topped 11%. Commodities produced a similarly strong result during periods of high inflation.
Some resource-related stocks offer an additional appeal as indirect inflation hedges: They are relatively cheap.
Currently, for example, the Bloomberg World Mining Index is trading for just 1.5 times sales, which is only one-fourth the valuation of the MSCI World Information Technology Index.
This striking contrast does not automatically mean the mining stocks are now a better bet than tech stocks, but it does suggest that the mining sector might contain more hidden gems than the tech sector.
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Not long ago, these two indices were trading for the exact same valuation. So, it wouldn’t be too surprising if these divergent valuations reunited at some point, either because tech stock valuations fell or because mining stock valuations rose… or both.
A rising interest rate trend is not a certainty, of course. But it is enough of a possibility to warrant concern… and perhaps a portfolio hedge or two.
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