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It's hard to avoid the word 'inflation' when reading through today's headlines. It's also front and centre when we're shopping for groceries or passing by a gas station. Every day it feels like life is getting more expensive and our money isn't going as far as it used to. That, in a nutshell is the effect of inflation at work - it erodes our purchasing power and can often eat away at the value of some of our assets.
There are many ways to track inflation, but most economists will look at the Consumer Pricing Index (CPI) as a gauge. CPI is a measure of the rate of change in the price of a basket of goods and services over a period of time. It can be simply described as the change in of the cost of living.
Generally, central banks are comfortable with CPI readings of around 2% per year. However, September's Statistics Canada measure the annual change in CPI at an elevated 4.1%. In the U.S, the September reading was even higher with the Bureau of Labor Statistics showing a rate of 5.3%. Neither nation has experienced this level of inflation for quite some time.
Transitory
The recent increase in prices is often explained as "demand driven and supply constrained", which simply means there are more buyers for fewer goods. It is largely thought that the money people saved during the COVID-19 Pandemic is being spent on the few goods that were produced during that same period.
The current period of higher inflation is also largely described as being "transitory" or temporary in nature, because the availability of goods is improving, and savings are being spent. However, if it isn't in fact transitory, and inflation stays elevated, there are steps you can take to protect yourself against the negative affects within your investment portfolio.
A "real" hedge
Real assets are often described as hedges against inflation. This means, that if inflation increases, the value of these assets should also increase. Real assets are physical in nature and their value comes from their substance and individual properties (like real estate).
One of the most significant features of real assets is their ability to pass through variable prices to the customer. What this means is that if their costs go up, they can charge more for their product or service. It is this element which makes owning real assets potentially beneficial in periods of inflation.
Real solutions from TDAM
TD Asset Management Inc. (TDAM) offers many different strategies to investors that can help protect their assets against inflation, and there are two within our Exchange Traded Funds (ETF) suite that are worth highlighting: The TD Active Global Real Estate Equity ETF and TD Active Global Infrastructure Equity ETF.
TD Active Global Real Estate Equity ETF (TGRE)
TGRE is designed to provide regular income and achieve long-term capital appreciation by investing in, or gaining exposure to, the equity or equity-type securities of real estate investment trusts (REITs) and companies that invest or operate primarily in the real estate sector located anywhere in the world.
How does TGRE mitigate the effects of inflation?
- Through rental agreements - Generally, these agreements include language that allow rental rates to increase in a manner tied to inflation.
- New leases at higher prices - Often when leases end or are terminated, new leases can be reset at higher prices which can account for the inflationary pressures within the economy.
- Increased replacement costs - When building input costs (steel, lumber, etc.) increase, the value of those buildings already in existence will increase to reflect the cost of reproducing them.
TD Active Global Infrastructure Equity ETF (TINF)
TINF is designed to earn income and achieve long-term capital appreciation by investing primarily in common equities, equity-linked notes, convertible securities, preferred shares or other equity-type securities of companies that own or operate infrastructure assets located anywhere in the world.
How does TINF mitigate the effects of inflation?
- Pass through variable costs to customers - Most infrastructure assets have means by which to pass-through variable costs to their customers which benefits their shareholders. Whether it's embedded in a contract, a concession agreement or a regulation, many infrastructure assets have a pricing formula with an explicit link to inflation. As an example, a 15-year power supply agreement by a wind farm would have embedded escalators linked to inflation. Not only does this help protect against the adverse effects of inflation but it also helps improve the predictability of future cash flows.
- Price control - Many infrastructure assets are also in strategically strong positions to control pricing when their costs rise. This allows them to dictate pricing if the inflationary environment warrants it. Much the same as real estate, when the input costs of building a bridge or dam increases, the value of those already built will appreciate.
One other key benefit of both the TINF and TGRE is that they are actively managed. This attribute gives the portfolio manager the added flexibility to adjust the portfolio to those holdings which have greater pricing power in inflationary environments.
Whether inflation is transient or longer term in nature, we believe both TINF and TGRE are well positioned and a worthwhile consideration for any portfolio. For more in-depth information on these strategies, please check out our papers Beyond Stocks and Bonds and Getting it right with REITs.
Tom Grant, Vice President
ETF Capital Markets,
TD Asset Management
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