There has been a lot of chatter recently about inflation, with many experts and investors expressing concern, for a good reason.
Last month, the Bureau of Labor reported inflation of 5.4% – the highest rate since 2008. Inflation rose 0.9% in June on a seasonally adjusted basis after rising 0.6 % in May, making the increase the largest 1-month jump since June 2008. So, not only is inflation at its highest rates in years, but its growth is accelerating – getting worse by the month. Inflation is never good news for the average investor.
Inflation is typically due to one of two sources:
- Free money printed by the government; or
- A red hot economy.
A red hot economy typically means low unemployment. In that situation, the Fed is inclined to reign in the economy by raising interest rates – at the cost of losing jobs – to prevent the much worse problem of runaway inflation.
The current situation – inflation fueled by freely printed stimulus money – is not ideal because unemployment is still high as the economy recovers from the pandemic. The Fed is reluctant to raise interest rates because many people are already out of work, and the Fed doesn’t want to send people who just got back into the workforce back to the unemployment lines.
The problem is: Will it be too late when the Fed does decide to address inflation?
If the past is any indication, once the Fed raises interest rates, the economy will slow as businesses and consumers have less to spend as the cost of borrowing goes up. The slowdown in production and consumption will hit the bottom lines of companies and stock prices. The average investor will liquidate their stocks in response – not only in response to lower stock valuations but to hoard cash as higher prices diminish their buying power.
In the alternative, if the Fed doesn’t respond by raising interest rates, runaway inflation will have the same effect on consumption as consumers experience less buying power.
The average investor’s portfolio is not safe in the current economic environment.
Whether the Fed raises rates or not, company bottom lines will take hits along with their stock prices no matter what happens. While the average investor may be vulnerable to inflation, investors who invest in demand have less to worry about.
In past posts, you have heard me advocating about investing in demand as a hedge against inflation and to shield from downturns.
What am I referring to?
The general effect of inflation is that consumers will have less spending power because they will roll back consumption. Many industries and market segments will see decreased demand as pocketbooks dwindle.
Although diminished demand is common with most goods and services in an inflationary environment, it’s not true with all goods and services. Some assets experience “sticky” inflation or “sticky” demand – meaning their prices rise along with inflation . . . for the long haul.
Although some goods and services see initial jumps in demand along with inflation, as inflation gets drawn out, demand for these goods and services eventually retracts. In contrast, goods and services with “sticky” demand or that experience “sticky” inflation trend upwards for the long haul.
Rental real estate is an asset that is expected to experience “sticky” demand during this latest episode of inflation. This means that rental rates will rise with inflation with no expectation of a retraction in the future.
That’s because higher rents are the kind of price increase that’s hard to reverse. That’s due to people always needing shelter due to the lock-up periods (typically 12 months) associated with lease agreements. Renters are stuck with their rental rates for 12-month periods at a time, and upon renewal, history has taught us that those rates aren’t likely to be reduced. All this means that as inflation gets worse, rental real estate rates dig in for the long haul.
Here’s how rents are trending:
According to Apartment List, the median national rent climbed 9.2% in the first half of 2021, with no expectation of slowing. Summertime is rental renewal season as most renters move when it’s warm, and their children are out of school. So this is the time of year when the largest number of lease renewals will come up – locking millions of tenants into bigger monthly rents. And renters are already expecting higher rents as surveys by the New York Fed and Fannie Mae suggests renters are braced for further hikes of 7% to 10% in the coming year.
Assets like rental real estate with “sticky” demand – sustained demand that tracks inflation – are ideal assets for hedging against inflation. Suppose an asset has demand that doesn’t falter and rents that stay in lockstep with inflation. In that case, that is the ideal asset for investors who don’t want to worry about diminishing income or portfolios in inflationary times.
Investing in demand is how sophisticated investors protect their portfolios, and it’s how every investor can protect their portfolios.
By following demand instead of shiny objects, these investors hedge against inflation and prevent losses the average retail investor will likely suffer to their portfolios once the Fed raises rates.