In response to the credit crisis, central banks authorities and governments around the world have taken unprecedented action in providing massive fiscal and monetary stimulus. Warren Buffett, in a recent interview with CNBC, said that such actions have the potential to be “very inflationary”. In the same interview Buffett had some suggestions for investors for preparing for any spike in inflation in the future:
But we are certainly doing things that could lead to a lot of inflation, and the best asset during inflation is your own earning power. Anything you do to improve your own talents and make yourself more valuable will get paid off in terms of appropriate real purchasing power. If you do something well, whether you’re a major league baseball player, you know, whatever it may be, if you’re a good assistant, whatever it may be, that’s the best asset. The–in my view, the second best asset is a good business. And you might own one yourself, but you might own it through equities.
He expanded on why he thinks stocks will be the second best asset class:
You know, if the dollar becomes way–worth way less, we will sell See’s Candy for more money. I mean, it won’t be more real dollars, but we–if somebody’s willing to give up 15 minutes of their labor or half to buy a pound of this or to buy six cans of this, they’ll do the same thing and it won’t make any difference whether shark’s teeth are being used for money, basically.
But, as Jeremy Siegel notes in Stocks for the Long Run, “neither stocks neither stocks nor bonds nor bills are good short-term hedges against inflation”. Over the long-term, though, “the real returns on stocks are virtually unaffected by the inflation rate”. The reason, as Buffett pointed out in his interview is that stocks are claims on the earnings of real assets “whose value is intrinsically related to labor and capital”.
There is evidence that other asset classes such as gold (over the long-term) and real estate provide some measure of inflation protection. The Canada Pension Plan also lists infrastructure among its inflation-sensitive holdings.
There will be one clear loser if inflation does spike in the future: traditional Government bonds. Retirees depending on portfolio income for maintaining their standard of living may want to consider keeping a large portion of their bond portfolio in real return bonds, which provide a perfect hedge against inflation. Interestingly, while long-term Canada bonds are yielding just over 3.5%, real return bonds are currently yielding a real return of 1.9%.