Investors should consider an updated inflation-hedging exchange traded fund strategy that could help better cope with the current inflationary pressures.
In the recent webcast, Inflation Strategies: How to Survive Extraordinary Times, James Davolos, portfolio manager, research analyst, Horizon Kinetics, outlined the shifts in fundamentals that has contributed to the elevated inflationary headwinds that we face today.
Specifically, Davolos noted that the U.S. money supply is up about 40% since the end of 2019. The Federal debt, the increase of which is linked to the money printing, is now the highest proportion of GDP that it’s ever been. About 13% of all the dollars ever created in the history of the United States of America were created in the past 12 months.
“If the economy cannot expand sufficiently to allow the debt/GDP ratio to gradually subside to a sustainable level, the government’s only politically realistic option — a timeworn solution — is to actually continue printing more money,” Davolos said.
Davolos also added that the benign inflation environment of the past decades has partly been a function of significantly reduced commodity prices, which is very unlikely to persist. It is becoming increasingly difficult to produce the raw materials necessary to support global growth at a high standard of living. Additionally, fiscal spending is likely to further pressure key commodity markets.
Investors are also faced with challenges when picking the right assets to invest in during these conditions.
“Cash and bonds are extraordinarily overvalued, at near-zero yields that are exceeded by the current inflation rate; stocks, by some measures, are overvalued beyond historical precedent,” Davolos said.
Robert Sechan, CEO, managing partner, co-founder, NewEdge Wealth, highlighted some of the shortcomings of traditional inflation-hedging investments. For example, Treasury Inflation Protected Securities, or TIPS, have been a go-to option for fixed income investors. However, he explained that inflation expectations and long-term interest rates are highly correlated; so outsized movements in interest rates relative to inflation can hamper returns on TIPS bonds. The TIPS price will only increase in value in the interim should inflation expectations rise relative to the 10-year yield.
Growth stocks, which have enjoyed a multi-year bull run, are also under pressure in this rising interest rate environment ahead. The strategists warned that growth stocks have almost infinite duration, or very high P/E levels, so they typically have a negative correlation with interest rates.
Alternatively, Davolos highlighted the benefits of the Horizon Kinetics Inflation Beneficiaries ETF (INFL), an actively managed ETF seeking long-term capital growth in real (inflation-adjusted) terms. It aims to achieve its investment objective by investing primarily in domestic and foreign equity securities of companies that are expected to benefit, either directly or indirectly, from rising prices of real assets (i.e., assets for which value is mainly derived from physical properties such as commodities) such as those whose revenues are expected to increase with inflation without corresponding increases in expenses.
“We consider companies that exhibit scalable, economically resilient business models,” Davolos said. “Many provide exposure to hard assets via capital-light business models.”
Potential investors should note that INFL is not a binary “bet” on inflation. The fund focuses on businesses with the potential to earn high cash flows under moderate inflation scenarios, but are markedly higher under certain rising inflationary conditions. This portfolio is intended to benefit from inflation (i.e. appreciate), not just maintain value in an inflationary environment.
INFL’s strategy focuses on hard assets with a capital-light approach. The capital-light business model requires less working capital and debt while earning higher returns on capital. This facilitates higher compounding of capital over full business cycles. These capital-light business models include areas like transaction facilitators, royalty & streaming companies, data & research companies, timber, agriculture, real estate, and infrastructure managers.
“We believe they improve the business quality of a portfolio and reduce the cyclicality — it’s not a ‘bet’ on inflation,” Davolos said.
Financial advisors who are interested in learning more about inflation hedging strategies can watch the webcast here on demand.