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The annual inflation rate in the US exceeded a 40-year high of 9.1% in June 2022, experiencing the sharpest increase in prices since November 1981. While inflation slowed to 8.3% in August, we will likely see an upward move. Most prices will remain under pressure for some time to come.
Yet, despite the current environment of declining stock prices and rising inflation numbers, some assets are well positioned to profit. For example, agricultural land performs well in an inflationary environment, enjoying a jump in both land valuations and commodity prices. Historically, agricultural land returns have had a correlation of about 70% with the CPI. Let’s explore the factors driving price upwards and how these trends have historically affected some of the top asset classes.
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factors driving inflation
As a result of over-stimulating the economy during the COVID-19 pandemic, the M2 money supply grew by over 40% from March 2020 to June 2022, while the M1 money supply grew by 5x. This influx of money into the economy helped propel prices to a 40-year high; Commodities like food now cost 10.4% more than a year ago.
Delays in shipments due to lockdowns, labor shortages and slow port turnaround times are causing supply shortages around the world. In turn, consumers are facing higher prices due to pass-through cost and lack of inputs. Although they have started to decline, for example, fertilizer prices have increased by 80% in 2021; Earlier this year, prices increased by an additional 30%.
The Russia/Ukraine war is adding to inflationary pressures especially on global food prices. Russia and Ukraine are major suppliers of commodities, especially staples such as wheat and corn; Combined, the two countries export about 25% of the world’s grain. Due to sanctions against Russia and transportation challenges within Ukraine, only a fraction of this supply is accessible to the rest of the world. As a result, wheat prices rose 37 per cent during the first two months of 2022, while corn prices rose 21 per cent.
While each period of inflation is different, the historical performance of some of the top asset classes can give an indication of how each might perform in today’s environment. Let’s take a look at how inflation could affect some of these top asset classes:
In general, the real return of stock prices declines as inflation rises. In fact, from 1979 to 2021, public equity returns have been significantly lower when inflation exceeds 4.1%. This performance is driven by higher prices for inputs, causing many companies to experience lower profit margins. In addition, strict monetary policy discourages borrowing due to the high cost.
However, some stock market sectors benefit in times of inflation. For example, rising oil and other commodity prices have driven energy sector stocks to post record profits in 2022; Energy Select Sector SPDR Fund (XLE) is up 42% this year.
Tighter monetary policy in response to inflation has historically negatively affected fixed income securities. When the Fed raises interest rates, as we see today, bond prices fall as yields become more attractive. As a result, the relationship between stocks and bonds tends to be strongest during long periods of high inflation, which means that bonds can also lose their diversification characteristics. This can increase volatility, especially for investors who rely on a “60/40” portfolio.
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Historically, inflation and housing prices tend to move in the same direction, making real estate a popular hedge against inflation. Inflation can also benefit investors who earn income from rental properties, as higher home prices often equate to higher rents. However, higher interest rates often cause investors to demand higher cap rates, which can negatively affect commercial real estate valuations. In addition, commercial real estate can be locked into long-term agreements that cannot be adjusted for inflation or rate changes.
While the track record for the digital currency is not long, it was recently discovered that the cryptocurrency does not appear to be as strong as an inflation hedge as originally anticipated. From mid-April to mid-July, the cryptocurrency was found to have a 95% negative correlation to 10-year US inflation-indexed bonds. Not only does the cryptocurrency run averse to inflation, but it has also recently failed to preserve the asset value, with bitcoin’s recent peak drop reaching losses of nearly 72%.
The long-term appreciation of agricultural land is driven by two major trends: rising food demand and land scarcity. Quality agricultural land is becoming increasingly scarce around the world; The United States lost 1.3 million acres in 2021 alone. Also, the global population is expected to reach eight billion people by the end of this year, while by 2050 will exceed nine billion. To meet expected global demand, farmers will need to double the amount of food they consume over the next 50 years – all while using less land.
Apart from price appreciation, agricultural investors can also benefit from the annual cash yield generated from agricultural operations. Therefore, when commodity prices rise, agricultural land returns should also increase. As a result, agricultural land has historically been well positioned to protect property value and generate income, especially in times of inflation. In a 50-year study of farmland returns (1970 to 2019), annual agricultural returns were 2.5 times the average annual CPI rate.
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Despite the fall in prices in August 2022, many expect inflation to remain around 8% for the rest of the year. Although inflationary fears, both domestically and overseas, remain constant, the opportunity for investors through both traditional and alternative options remains immense.