Consumers and investors pay close attention any time a new announcement is made about movements in the US Consumer Price Index (CPI), which is a reliable indicator of inflation or deflation. While consumers worry about the effect of inflation on their purchasing power now, investors worry more about how inflation will affect their purchasing power in the future.
During times of high inflation, as the cost of goods and services begins to rise, faster than expected, investors will reassess their current strategy and portfolio allocation to ensure the long-term health of their investments. If a portfolio does not grow faster than the rising cost of goods and services, it means that it is losing value in real terms, as the purchasing power it represents declines over time.
For investors looking to protect their portfolios against inflation, assets that produce fixed income, such as bonds, will actually produce a lower and lower real return over time. To preserve future purchasing power and counter the effects of inflation, investors are increasingly turning to variable-return assets, including traditional options like stocks and commodities. However, as access to cryptocurrencies has widened, investors are also integrating them as a hedge against inflation.
Ways investors try to make their portfolios inflation-proof
The first action investors typically take during times of inflation is to reduce their portfolio allocation to bonds, which typically perform poorly during times of inflation and are unlikely to generate real returns. However, investors have the option of purchasing inflation-linked bonds. In the United States, for example, Inflation-Protected Treasury Securities (TIPS) are a popular option because they are indexed to the Consumer Price Index. However, the CPI is not seasonally adjusted and may underestimate inflation. Additionally, TIPS are considerably more volatile than cash, especially during stock market crashes, and tend to underperform traditional Treasuries over the long term.
Real estate is another inflation-proof investment option, as any debt used to fund it will be eroded by the effects of inflation. As a caveat, investors should take a close look at the type of leverage mechanism used to purchase real estate, especially on the cusp of a market bubble. When the bubble bursts, the investor could end up with an “upside down” mortgage, where the amount of money he owes on the property is more than the value of the asset.
To ensure value retention in the face of inflation, some investors may increase their allocation to equities, which may outperform bonds. However, performance will depend on the type of stock as well as its valuation at the start of the inflation period. Commodities, such as crude oil or metals, tend to do well in times of high inflation. Investors should be careful, however, as some commodities, such as cotton, can fluctuate quite quickly again. The most popular long-term protection against inflation is gold. Gold has been used for thousands of years as a scarce commodity with properties similar to those of silver. The advantages are that it is easy to understand and has a store of value that shouldn’t change drastically over time. Gold is not free from its own volatility issues, however, which has led some investors to explore additional alternatives for portfolio diversification.
Adding crypto as an anti-inflation asset
Mike McGlone of Bloomberg Intelligence recently said that Bitcoin is on the way to replacing gold. Those who understand Bitcoin’s limited supply and hard-coded inflation rate have dubbed it “digital gold.” Over 18.5 million of the 21 million Bitcoin total supply have already been mined, with the remaining supply being generated at an increasingly slower rate until the final Bitcoin is created in 2140. Bitcoin is therefore a form of “healthy currency” or hard currency, possessing characteristics that make it an effective store of value.
It took over a decade for Bitcoin to be accepted, with 2020 proving to be a pivotal year. Leading investors such as Tesla, Inc. (NASDAQ: TSLA) and MicroStrategy Incorporated (NASDAQ: MSTR) brought cryptocurrencies into common parlance, and in March 2021, Morgan Stanley (NASDAQ: MS) became the first US bank to allow its customers to access Bitcoin funds. Even billionaire hedge fund manager Ray Dalio himself admits he “would rather own Bitcoin than a bond.”
Institutional investors are starting to understand that Bitcoin has its place in a diversified portfolio and that even allocations of 1 to 2% can lead to significant increases in the Sharpe ratio, which measures and compares the performance of investment products against assets. without risk. A June 2020 analysis by Iconic Holdings, which provides exchange-traded products (ETP), found that a traditional 80/20 equity bond portfolio saw its Sharpe ratio drop from 6.6 to around 8 , 2 with 1% crypto, 9.5 with 3% crypto, and 9.8 with 5% allocated crypto.
Investors should be aware that crypto capital gains are likely to be taxed in the same way as capital gains from other asset classes, although this depends on the jurisdiction of the person. Long-term capital gains are preferable to short-term capital gains, so investors are advised to look for cryptocurrencies that they would be comfortable holding for the long term.
Opportunities for low risk returns in crypto
It is possible to generate a return in the digital asset space in a similar way to the return previously offered by fixed income products, as well as through low risk return opportunities. For example, more than 8% per year can be earned by lending stablecoins, which are assets whose value is tied to fiat currencies like the dollar or the euro.
One feature of digital assets that is even more widely used than lending is staking, a process by which assets are used to verify blockchain transactions and earn rewards for doing so. According to Staking Rewards, a data provider for staking and crypto-growth tools, over 70% of the supply from Cardano and Solana is staked, and over 50% of the supply from Polkadot, Algorand, Binance Coin. and Avalanche.
The newest and most sophisticated way to generate a return in the digital asset universe is to provide liquidity to trading pools on decentralized exchanges. These “exchanges” are actually programs running on the blockchain that rely on a type of smart contract called an automated market maker to facilitate token trading. Users can earn a share of the trading fees by placing their assets in a cash pool, with the rewards automatically adjusting to ensure each pool remains sufficiently liquid to support the volume of ongoing transactions. All of this is made possible by the smart contract functionality of blockchains like Ethereum, and, along with on-chain lending and borrowing, is the emergence of “decentralized finance” or “DeFi”.
Everyone should have the same access to anti-inflation asset options
With the US CPI rising above 5.4%, inflation is already very present. While the Federal Reserve maintains that this is a temporary state of inflation, the market will likely begin to react to this new reality, if inflation does not decline in the near future, and certainly if it continues to fall. to augment. Investors who do not look at the allocation of their asset portfolios may end up with reduced future long-term purchasing power.
Currently, many traditional investors may find themselves excluded from the opportunities presented by cryptocurrencies and DeFi, as participation is still largely limited to those with significant technical knowledge or knowledge of the crypto ecosystem. However, large swathes of the digital asset industry are struggling to remove barriers and improve access to these earning opportunities for everyone, regardless of their technical skills.
The barriers that prevent investors from understanding how to integrate crypto into their portfolio are being removed one by one. Traditional banks and investment brokers, such as Charles Schwab Corporation (NASDAQ: SCHW) have started educating their clients about digital asset classes and how to invest in them. The platforms, where people can buy or trade cryptocurrencies, have become widespread with PayPal Holdings Inc. (NASDAQ: PYPL) and no longer feature confusing interfaces that scare potential non-technical investors.
Inflation doesn’t discriminate – it affects the cost of goods for everyone, regardless of the economic demographics they find themselves in. Therefore, enabling the greatest number of investors at all levels to access the widest variety of high yielding assets is important to hedge against inflation and maintain their purchasing power over time. term.
About Marius: Marius Smith is the Business Development Manager at Finoa, a European platform for custody of digital assets and financial services for institutional investors and businesses. Before joining Finoa, Marius worked at N26 and Google.