Responses to Inflation

Kenneth A. Carow, PhD, CFAIndianapolis, IN

April 19, 2023

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Consequences of Inflation

• Increases in prices• From commodities, to wages, to general prices

• Reduced buying power for currency, affecting international trade

• Increased taxes as prices rise and governments continue to take a percentage of increased prices, including expected capital gains taxes

• Government debts are able to be paid back in inflated dollars, reducing the impact of the government deficits, but creating future issues with government access to capital.

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Investors:Securities to consider

• Treasury Inflation Protected Securities (TIPS)

• 1-year, earning CPI - .7%

• 10-year, earning CPI + 1.3%

• 20-year, earning CPI + 1.7%

• Short-term bonds (very low yields)

• 1-year, yield 0.4% (preservation of capital)

• 10-year, earning 3.5% (increasing rates would decrease prices resulting in capital gains losses)

• 20-year, earning 4.1%

• Commodities

• Gold is considered an inflation haven, but it may be priced in at $1200

• Exchange traded funds can provide a simple method of purchasing a basket of commodities.

• Companies producing commodities

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Investors:Securities to consider (cont.)

• Will inflation be global or more likely in some countries than others?• Inflation is more likely in countries with significant debt• One method of inflation is currency devaluation, making

products more expensive in the country where the currency has been devalued.

• Conclusion: Invest in currencies/markets that have lower debt levels.

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InvestorsSecurities to Avoid.

• Long-term bonds (Treasury, Munis, and Corporates)• Treasury 1-year, yield 0.4% (preservation of capital)• Treasury 10-year, earning 3.5% (increasing rates would

decrease prices resulting in capital gains losses)• Treasury 20-year, earning 4.1%

• Most financial stocks – especially ones with fixed rate loans and variable deposits.

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Federal Reserve Balance Sheet

http://delong.typepad.com/sdj/2009/07/federal-reserve-balance-sheet-with-added-background-image-of-ben-bernanke.html

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InvestorsAdvantage of Roth IRAs compared to Traditional IRAs

• Roth IRA taxes the money up front but has no tax at withdrawal

• Traditional IRA gives a tax break now, but pays taxes upon withdrawal in the future.

• Greater inflation implies that there should be greater capital gains in the long term as more dollars are needed to buy companies. This implies greater capital gains in the long term. The Roth IRA pays taxes in current dollar terms and does not have to pay taxes on the increased capital gain accumulation.

• If inflation is spurred by government debt, expect increased future tax rates, so paying taxes today (Roth IRA) provides advantage relative to higher future rates

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Businesses – General Financing strategy• Borrow using fixed rates.

• Rates are currently very low, inflation will imply increasing interest rates

• Many banks focus on adjustable rate loans, if these can be linked to collateral (mortgage) they can sometimes be set as fixed rate debts. Expect fixed rates to be greater than adjustable rates in the short-term, but benefit the company in the long term as adjustable rates will rise with inflation.

• Increase the amount of debt in capital structure

• Borrow while rates are low so that you can repay in inflated dollars in the future. The funds add to your liquidity; however, in the short-term the return on these liquid funds will not cover the costs of the interest to the bank.

• Nothing is free! Inflation hedges bring with them risk as well as costs.

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BusinessesQuestions: Are you in a service

Industry

yes no

Is your business associated with a

commodity?

noyes

Is the commodity a revenue or an

expensenoyes

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Service Industries (or non-commodity based industries)

• In service it is generally easier to pass on cost increases. Increased cost of employees are generally passed on to customers, although reluctantly.

• Companies can inadvertently expose themselves to inflation risk if they contract with customers to provide services at a set price in the future. This results in locking in revenues even though wages for the services may rise with inflation. Contracts that allow for increases in inflation can provide a better hedge against inflation.

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Commodity Industry – where commodity is a revenue

• For those that produce something like lumber, food, steel, oil that is sold to your customers – you are a potential beneficiary of inflationary pressures.

If inflation primarily affects revenues (commodity)

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If inflation primarily affects expenses (commodity)

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Using Futures to hedge increasing commodity expenditures

• Go long (buy) futures on the underlying commodity• If the commodity you purchase does not have a

futures contract, research which futures contract has a high correlation with your commodity.

If profits decrease with expected inflation, such as

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Add Futures on Commodity if inflation increases commodity price

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Prices assume to increase with inflation

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Combining our two positions:Profits without futures plus futures payoffs equals net profits.

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Responses to Inflation

Kenneth A. Carow, PhD, CFAIndianapolis, IN

April 19, 2023