The recent pandemic has tested portfolios’ resilience against one specific type of risk. Covid-19 introduced a sudden, exogenous shock to demand and production that led investors to shift money into assets that had already been deemed “safe”, namely those with predictable profits that had done well in the recent past. We believe that much of this shift in capital is likely to be temporary. But in the short term, it favoured the very assets we have been studiously avoiding for their price risk. 
This is certainly a test of nerves. To perform well in the long term, investors must remain resolute in these times by investing sensibly in assets priced below their intrinsic value, while at the same time attempting to mitigate against a wide variety of risks. The recent Covid-related shock to productivity and consumption, and the resultant widening of the divide between market winners and losers as investors shifted money into market darlings, does not mean that other risks have disappeared from the market. In fact, just the opposite may be true. Recent price moves have made expensive assets more expensive, and cheap assets even cheaper. At the same time, the central bank action that is fuelling high prices in “safe” assets has the potential to create another risk that could destroy those assets’ values: inflation.
To see how inflation could arise, it’s useful to follow the money. To prop up prices and keep credit flowing in the face of uncertainty, the Fed buys securities from banks and pays for them by crediting the banks’ reserve accounts with newly created money. If there is more money chasing the same quantity of goods and services, prices will have to go up, spurring inflation. Money printing is not a guarantee of inflation, however. The banks could stash the money in their reserve accounts, leaving it stuck and unable to stimulate the economy and prices. Or people could hoard cash rather than spending it. Coupled with tepid growth in wages and input costs, as we have seen recently, this consumer caution can put downward pressure on prices, counteracting the inflationary pressure of the Fed’s actions. So far the deflationary pressure created by decreased consumer spending seems to have balanced the inflationary pressure caused by the increase in the money supply. But if spending returns to normal in the wake of the virus, that balance could shift and send inflation rising higher.
As importantly, the economic shock caused by the lockdowns forced an unprecedented fiscal response, with the US Treasury backing forgivable loans to employers, sending checks to individuals, and increasing unemployment pay-outs. Trillions in government spending can also spur inflation. Indeed, the enhanced unemployment benefits have already led to talk of labour shortages as workers refuse to come back to work for their old wages. It is not unreasonable to predict that this phenomenon may, over time, lead to upward pressure on wages, or even increased demands for some sort of universal basic income. Reduced immigration and increased barriers to trade, another probable result of the virus, could likewise increase the cost of goods and services. Finally, increased focus on corporate social responsibility to both workers and the community could lead to higher wages and more money in the hands of some of the nation’s poorest individuals. This would be a welcome result for society, and it would also likely boost inflation, as lower-income workers tend to spend (rather than invest) a larger portion of their income.
Given the above dynamics, inflation seems to be a risk worth protecting against. At the same time, because it is not currently viewed as the headline risk feared by most investors, protection against it is relatively cheap. In other words, we have the opportunity to be contrarian not only in our search for returns, but also in our search for risk protection. A happy by-product of this contrarian stance is that our risk reduction may actually represent an opportunity for reward as well, since assets that are viewed as inflation hedges are likely to increase in price if and when inflation fears become more common.
It is partially on this reasoning that we currently hold 11 per cent of the portfolio in gold-related assets: gold provides a diversifying asset class that can also act as an effective inflation hedge.
This quarter, we supplemented our gold-related position with another asset that shares those qualities – US Treasury Inflation-Protected Securities, or TIPS. TIPS are long-term government bonds, which we have warned against repeatedly over the last few years, and we continue to find most long-term government bonds uninvestable. But TIPS are different. They are as safe as normal government bonds in terms of repayment, but while normal government bonds are vulnerable to inflation, TIPS pay out more if inflation goes up, protecting the holder against a loss in purchasing power. That protection is relatively cheap today, as few investors are worried about higher inflation. In fact, in the past, buying TIPS at these levels has been very rewarding compared to owning standard Treasuries.
While the drivers of inflation and deflation are complex and hard to predict with certainty, we do not need certainty to make gold or other inflation hedges good investments in today’s environment. We simply need to believe that they provide a bargain from a risk/reward standpoint, decreasing portfolio risk without being overpriced, and at the same time providing the possibility of attractive returns.
Ashley Lynn is co-manager of Orbis Global Balanced fund. The views expressed above are her own and should not be taken as investment advice.