The March Consumer Price Index came in hotter than expected, making three consecutive monthly price increases for the closely watched basket of goods and services in the CPI report, dashing investors’ near-term rate cut hopes.
Fed Funds Futures have pushed out the next best chance of a rate cut from June to September, as the bond market is pricing in higher-for-longer rate expectations.
With that inflationary backdrop, now is a good time to revisit the best ETFs for inflation in the shifting 2024 economic environment.
What’s Causing Inflation in 2024?
Inflation is the increase in the prices of goods and services in an economy over time. There can be many factors that contribute to a rise in consumer prices, but the general cause of inflation is a surge in demand for goods and services without sufficient supply to meet that demand. Here are factors contributing to inflation in 2024:
Lingering effects of the pandemic: Supply chain disruptions caused by pandemic-related shutdowns and logistical bottlenecks are still affecting some industries. This limits the supply of certain goods, leading to price increases.
War in Ukraine: The ongoing war has caused significant disruptions to global energy and commodity markets, pushing up the prices of oil, natural gas, wheat and other key resources. These higher costs are then passed on to consumers through higher prices for goods and services.
Monetary policy: While some central banks are raising interest rates to combat inflation, the loose monetary policies implemented during the pandemic, like aggressive quantitative easing, might still be playing a role in inflation persistence.
Wage pressures: Labor shortages in some sectors are leading to wage increases for workers. While this is positive for workers' compensation, it can also contribute to higher production costs for businesses, which may translate to higher prices for consumers.
How Does Inflation Affect Investments?
Inflation is a normal aspect of a functioning economy. However, when inflation is abnormally high, it can result in declining prices for many different types of stocks and bonds. Yet some investment assets, such as certain commodities and inflation-protected securities, can outperform the broader market indexes during periods of high inflation.
In general, high inflation negatively impacts the prices for most stocks and bonds. This is because the Federal Reserve will attempt to fight inflation by raising interest rates.
How Inflation Affects Stocks
While stocks are generally good investments for fighting inflation over time, high inflation can negatively affect stocks in the short term. Higher rates generally cut into the profits of corporations by increasing their borrowing costs, thereby reducing profits.
Since higher interest rates make future cash flows look less attractive to investors, growth stocks tend to decline in price more than dividend-paying value stocks during periods of high inflation.
How Inflation Affects Bonds
Bond prices generally move in the opposite direction of interest rates, which means inflation is generally a bad environment for most fixed income securities. The longer the duration of the bond, the greater the sensitivity to a change in interest rates.
Therefore, when inflation is high and interest rates are rising, long-term bonds, and the ETFs that invest in them, can fall in price faster and further compared to short-term fixed income securities.
What Are the Best ETFs for Inflation?
While there is not a specific inflation ETFs category, there are types of funds that have generally outperformed the broader market indexes during periods of high or rising inflation. A specific example is a TIPS ETF, which may track an index of Treasury inflation-protected securities that are linked to increases in inflation.
Some of the best ETFS for high or rising inflation include:
TIPS ETFs
Commodity ETFs
U.S. Dollar Currency ETFs
Precious Metals ETFs
TIPS ETFs
TIPS ETFs track an index of Treasury inflation-protected securities, which means the principal value of the underlying securities adjusts with movements in inflation. Investors should keep in mind that TIPS can decline in price when inflation is rising but weaker than expected.
Commodity ETFs are exchange-traded funds that seek to track the price movement of an underlying commodity or index. During periods of high inflation, the prices for commodities, such as oil, tend to rise.
Unlike typical ETFs that invest in stocks, bonds, or commodities, US dollar currency ETFs don't directly hold US dollars. Instead, they typically use derivatives like futures contracts or currency swaps to achieve their exposure.
For example, they may us USDX futures to bet against the currencies of major U.S. trading partners, such as the eurozone, Japan, and Canada. This allows the ETF to profit from a rising US dollar compared to the contracted currencies.
Precious metals ETFs, such as those that track the price of gold or silver, can be a potential hedge against inflation. For example, gold is seen as a safe-haven asset. During economic uncertainty or market downturns, investors often flock to gold, potentially driving up its price and the value of your ETF.
That said, the price of gold can be volatile in the short term, and precious metals ETFs may experience price swings that don't directly mirror inflation. Furthermore, neither gold nor silver have historically outperformed inflation in the long term.
Types of ETFs that can perform relatively well during periods of high inflation include TIPS ETFs, commodity ETFs, U.S. dollar ETFs and precious metals ETFs. Investors should note that these funds are not guaranteed to gain in price when inflation is rising and determining how to invest during inflation is primarily dependent on an individual’s time horizon and tolerance for risk.
Timeless investment strategies that can help reduce market risk during periods of high inflation include diversification of assets and dollar-cost averaging. Diversification involves the process of spreading risk across different asset classes, such as stocks, bonds and commodities, as well as a range of investment categories, such as different market capitalizations, sectors and global exposure.
