Are ETFs protected against inflation?

With many parts of the world in pandemic recovery, rising prices of everything from crude oil to used cars has been affecting global economies. CPI figures in Canada and the U.S. saw a strong rise in 2021 as many components of total and core CPI saw price increases. U.S. total CPI saw a jump of 5.4% Y/Y during the September release, fueled by rising energy prices, rents, and auto prices. In Canada, CPI also jumped to 4.4% Y/Y with similar inputs affecting prices.

Although the rate of increase has slowed, inflation expectations are expected to remain elevated. Its effects could continue into the rest of 2022, with most of the acceleration in prices already past us. We see energy prices continuing to be a large component of short-term inflationary pressures.

Inflation may be one of the most significant risks to investment returns this year, however, there are some investments that can provide a level of protection, particularly on a tactical basis. Below, we review asset classes that provide protection to inflation.

Equities can offer a buffer against inflation as rising prices can potentially increase revenue, and may boost share prices. However, inputs such as raw commodities can erode profit margins and may negatively impact share prices. The ability to pass price increases to consumers while managing input costs can differ by sector. Sectors that benefit from rising input prices, such as energy and materials, can see strong performance as these prices pass directly to the consumer. Real estate is another sector that can provide protection in inflationary periods as rents and property prices see increases. However, recent developments in faster rate hikes in Canada could impede some of that protection, as REITs are sensitive to rising rates. Consumer staples usually pass price increases to consumers as demand for goods, such as groceries, tend to be inelastic.

Using equity factor strategies can be a way to gain broader exposure to areas of the market with certain characteristics. One such factor, value, tends to battle inflation due to its pro-cyclical nature and can weather these pressures better than growth stocks, which could be negatively impacted if rates rise. Additionally, many dividend strategies can be negatively impacted if distribution amounts don't increase to offset inflation. Dividend strategies that focus on dividend growth can help combat some of that pressure.

Historically, traditional fixed income has a negative relationship with inflation, tending to increase with duration. Treasury inflation protected securities (TIPS) issued by the U.S. Treasury and real return bonds (RRBs) issued by the Bank of Canada breaks this relationship by providing investors a similar return to nominal bonds with added inflation protection. In a period where fixed income is becoming more challenging to own, TIPS and RRBs can alleviate some of the risks of owning the asset class and is easily accessible using ETFs. Additionally, the Fed has been purchasing a higher number of TIPS during the latest quantitative easing, compared to the previous QEs in recent history.

Recently, it was announced that a reduction in purchases will be occurring, which could taper some demand. We would also caution that using TIPS/RRBs should be a relative trade involving a swap from traditional treasuries/federal bonds, as adding a new position increases duration risk in a portfolio.

With inflation comes the risk of rising rates. With both the Fed and BoC looking to raise rates from all-time lows during the pandemic can wreak havoc within traditional fixed income allocations in a portfolio. Floating rate securities, including investment grade notes and senior secured loans, can ease some of this negative pressure.

One asset class that has been a widely understood hedge for inflationary pressures is gold and precious metals. This physical asset class has historically shown to hold its value in real terms. ETFs tracking gold and precious metals have been in outflows recently, due to weak performance. However, growing risk of stagflation trends could increase demand for the yellow metal, which makes this asset class very compelling to own on a tactical basis.

Cryptocurrency has been very popular with retail investors during the pandemic. Some investors also see cryptocurrencies, specifically bitcoin and ether, to be a hedge against inflation. However, data is limited and caution is warranted. The rise of physical crypto ETFs in Canada has made it very easy to allocate to this asset class.