A client recently contacted me about the possibility of a surge in inflation due to massive government spending in response to the COVID-19 pandemic.

Governments and central banks are pumping trillions of dollars into the economy—in effect printing money—to alleviate unemployment, prevent bankruptcies and maintain the stability of the financial system, among other purposes.

Our client was asking if this flood of money could provoke a large upswing in inflation and wonders how we are protecting portfolios against the potential for rising prices.

Can we predict if there will be higher inflation?

Whether or not the infusions of money will lead to higher inflation in the U.S., Canada and other developed countries is the subject of a lively debate among economists. Some are more worried about deflation, at least in the short term, with economies in lockdown and the price of oil collapsing.

During the 2008-09 financial crisis there were also worries about a burst of inflation due to huge fiscal and monetary stimulus packages, yet inflation remained low. Still, an increase in inflation this time when the economy recovers is a possibility, though far from a certainty.

Which asset classes provide the best protection against inflation?

Many consider gold and other commodities to be a good inflation hedge. While it is true that commodities in general, and gold more specifically, tend to move in the same direction as inflation, the problem with these assets is you also take on a sizeable amount of volatility to get the inflation protection. In 2018, the Vanguard group wrote a very good piece on inflation hedging assets and their impact on portfolios.

Real estate investments are also often touted as a hedge against inflation. The argument we often hear is that rent tends to increase with inflation and the hard asset of a building tends to gain value with inflation as well. Unfortunately, the data on publicly traded real estate investment trusts (REITs) tends to show otherwise. Though we do hold REITs in PWL portfolios, it is not for their inflation protection properties.

Short term bonds are often overlooked as an inflation hedge. As interest rates rise in response to higher inflation, short-term bonds allow investors to reinvest at higher rates relatively quickly. All PWL portfolios hold an allocation to short term bonds, both to mitigate overall volatility and for their inflation protection properties.

Inflation isn’t the only risk!

That being said, we are always careful to balance our attention to the risk of rising inflation with the other competing risks we manage in portfolios. This is because we know that no one can predict the future. Instead, we maintain a balanced approach to managing risk—protecting against all sorts of different risks in a measured way.

Therefore, we wouldn’t favour aggressively tilting portfolios to benefit from a predicted inflation surge because if we bet heavily on one risk, it translates into letting down our guard on others, such as sector risk, economic growth risk or commodity risk.

The big danger in investing is incurring a permanent loss of capital, stemming from portfolio concentration, bailing out of markets during high stress episodes, inappropriate financial leverage or investing in strategies one doesn’t understand (as we saw in a massive loss by Alberta’s AIMCo pension fund).

A balanced approach to portfolio construction, periodic rebalancing and patience are the keys to successful investing through good times and bad.