How To Inflation Proof Your Portfolio
Being an income investor is not easy in this low-interest-rate environment. To add salt to the wound, inflation is picking up thick and fast, which makes the life of an income investor even more difficult as real rates are abysmally low in the United States. Following the Fed’s most recent meeting, the bond market reached a tipping point as the Fed confirmed its confidence in allowing inflation to heat up to new highs without any interference in the form of rate hikes. As challenging as it might sound for income investors, there are unique exchange-traded funds that offer current period income and protection from inflation. Strategy Shares Gold-Hedged Bond ETF (GLDB) stands out as one of the best-in-class ETFs for income investors who are cautious about rising inflation.
Real yields remain lackluster
The Fed is keeping policy rates low, the labor market is yet to recover fully, and inflation is continuing to make new highs. Put all this together, and the result is negative real yields.
Exhibit 1: Declining U.S. 10-year real yields
Commenting on the declining real yield, Michael Kushma, chief investment officer for Morgan Stanley Investment Management, said in an interview:
“Real yields could touch new lows if the Fed remains committed to keeping monetary policy unchanged. The more they push out their forward guidance of when they’re going to — and how fast they’re going to — raise rates, the more yields can stay low and, if inflation stays high, real yields can continue to remain very low.”
The language used in FOMC meetings makes it very clear that the Fed is laser-focused on avoiding the grave mistake of prematurely hiking interest rates, and this confirms the going will not get any easy for income investors.
Gold as an inflation hedge
Although some investors believe that gold is the best inflation hedge for all markets, there’s resounding proof to suggest that gold performs well under certain conditions only. Returns on gold and changes in the Consumer Price Index have historically had a skewed linear relationship. According to CAIA, only 16% of the fluctuations in gold prices since 1971 can be explained by variations in CPI inflation.
Exhibit 2: Correlation between percentage YoY change in gold prices and U.S. CPI
That being said, there’s no argument about gold’s ability to weather economic storms and deliver positive returns during difficult market conditions. Gold has traditionally outperformed the stock market during downturns and periods of high inflation, with the gold price climbing 15% on average during years when inflation was greater than 3%. Gold outpaced all other major asset classes in the first half of 2020, increasing 16.8% in U.S. dollar terms, once again highlighting the precious metal’s value as a hedge against market corrections.
Exhibit 3: The performance of gold during stock market crashes
Source: Gold Silver
Even though global equity markets have recovered sharply from the lows seen in the first quarter of 2020, there is significant uncertainty regarding the pace of the economic recovery because of the increasing spread of the Delta variant of the Covid-19 virus. This uncertainty has resulted in strong demand for gold. This increase in demand, coupled with the fact that gold is more effective than U.S. Treasury Bills in keeping up with the increasing money supply, makes the precious metal a best-in-class asset to preserve wealth.
Exhibit 3: Gold, money supply, and CPI
Given that gold prices tend to outpace money supply growth, income investors should ideally focus on investment products that provide them with exposure to gold as the global money supply is likely to expand at a stellar pace in the coming months as policymakers pump trillions of dollars into the global economy.
The strategic way to hedge against inflation while enjoying periodic income
GLDB offers investors a unique way to generate income that could maintain its purchasing power. To understand the investment strategy better, please refer to the below excerpt from the summary prospectus.
“The Index seeks to provide 100% exposure to the U.S. dollar-denominated investment-grade corporate bond sector (the “Bond Component”) plus a gold inflation hedge with a notional value designed to correspond to the value of the Bond Component, with such notional value reset on a monthly basis (the “Gold Hedge Component”). The Bond Index aims to mirror the performance of investment-grade corporate bonds issued in U.S. dollars. The Gold Hedge Index tracks the performance of the near month gold futures contracts listed on the Chicago Mercantile Exchange.”
The primary objective of this fund is to offer an investment vehicle that combines a bond portfolio with a gold hedge overlay into a single product.
Exhibit 5: Top-10 holdings of the ETF and sector weightings
Source: Q2 Fact Sheet
The fund primarily invests in investment-grade corporate bonds issued by publicly listed companies in the United States, and the exposure to gold acts as a hedge against inflation.
Despite a healthy economy and rising inflation, the bond market continues to surprise Wall Street analysts, as long-term Treasury yields continue to fall. The sustained decline in real rates implies that market confidence is deteriorating in the wake of the rapid spread of the Delta strain, which threatens to derail the recovery. In this scenario, bond investors should strategically invest in a fund that can provide a hedge against inflationary risk because inflation can and will have a material impact on the purchasing power of money. GLDB is an ETF designed on the basis that gold will protect bond investors from a rapid deterioration of the purchasing power, making it a desirable investment alternative for income investors concerned about an unexpected surge in inflation.