In this content I am presenting my personal opinion as an active private investor. This content is not intended to provide investment, financial, accounting, legal, tax or other professional advice and should not be relied upon or regarded as a substitute for such advice.

The inflation fallacy and its impact on Pure Climate Stocks

The inflation fallacy and its impact on Pure Climate Stocks

Currently, inflation is the big topic on everyone’s tongue. And with the growing buzz around rising prices, a variety of tips and strategies have been floated for investors to protect against it.

When it comes to inflation, however, investors should be very careful not to believe everything they read. While some points are fundamentally correct, there’s also a lot of nonsense – mixed with unrealistic promises – out there. Many of the people giving out advice may not have actually fully understood inflation protection.

One of the most important topics, and one that has been scarcely mentioned, deals with inflation expectations.

The role of (un)expected inflation

It turns out that people who invest in assets that could serve as a buffer against inflation – for example, commodities, raw materials (including metals), real estate, stocks, or inflation-hedged bonds – are not really protecting themselves against current inflation. Mainly, they are protecting themselves against unexpected inflation.

In simple terms, if the market expects 10% inflation over a year, commodity prices will rise 10% today. Therefore, if you’re buying today, you’re not actually protecting yourself from present-day inflation, since the price has essentially been locked in already. On the other hand, if inflation comes out at 15% but the market expected 10%, there will be 5% unexpected inflation. The assets mentioned above become useful in this scenario and can actually protect against this extra 5% bump – but not against the broader trend of inflation itself or, if so, just barely.

Let’s take a look at a simple example to illustrate the point. Say you used to be able to buy a 1 liter milk carton for $1. Better yet, let’s go with oat milk since it’s the climate positive alternative (and it lasts much longer)! And you’ll have to suspend disbelief for a moment, since unfortunately the sustainable alternatives like oat milk are always more expensive than $1… Now, after inflation, it costs $1.25. This 25% price increase is the direct result of inflation. No matter what you do, you can no longer protect yourself against this 25% bump. Now let’s pretend you go on a shopping spree – picture, for a moment, the toilet paper panic buys at the beginning of the pandemic – and buy 20 liters of $1.25 oat milk to stash away in your bunker. Such stockpiling against an oatmilk drought would protect you only if the price rises unexpectedly again – say, to $1.5 per liter. If the price dips back to $1, you can also end up losing money. And if the whole market would expect the price to rise from $1.25 to $1.5 in a single week, everybody would buy today and the price would jump immediately. The expectation is therefore immediately included in the price.

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What inflation is priced in today?

Fortunately, the pricing of inflation can be calculated quite easily. Expected inflation levels correspond to the yield difference between government bonds with fixed interest rates and inflation-indexed government bonds.

A U.S. government bond with a remaining maturity of a year currently has a yield of 1.97%.

A similar federal bond, the Treasury Inflation-Protected Security (TIPS) – one which pays an interest rate equal to the inflation rate – has a current yield of -3%.

So what does this tell us?

  • The expected inflation priced in today is 5%, or the difference between the two yields. If this inflation rate does occur, both government bonds – whether inflation-protected or not – will perform identically.
  • If the inflation rate over the next 12 months is above 5%, the inflation-protected bond will benefit.
  • However, if the inflation rate ends up being lower – say 4%, which would still be high inflation – then the inflation-protected bond will underperform by 1%.

This calculation is based on inflation-protected bonds specifically, but it can be assumed that this expectation is then priced in everywhere across financial markets.

Getting the timing right on inflation protection

By now, everyone knows all too well that we are living under inflation. It currently stands at around 8%. The market expects it to rise a bit further, and that expectation is what is already priced into all these investment opportunities.

If we look at Google Trends, we see that most people don’t really care about inflation (let alone inflation protection) – until there is inflation, of course.

Google Trends - INFLATION

Yet in reality, inflation protection measures need to be made permanent and taken even when – or especially when – there is no inflation actually occurring.

Inflation protection is always important

Inflation is relatively easily dealt with – at least, so long as we don’t experience wild hyperinflation, which we currently are not seeing, fortunately. Nevertheless, it’s very important not to rush into action only after it’s too late. Rather, it’s prudent to always build up a portfolio that is prepared for such situations.

So in summary: inflation protection is always important and not only in inflationary times.

By all means, if you want to protect yourself right now, do so! Just remember that it won’t undo the effects of current inflation. But critically, it will protect you against future and unexpected inflation.

Pure Climate Stocks and the inflation situation

What’s true for the global stock market is true for pure climate players: future inflation expectations are already baked into the stock prices of Pure Climate Stocks. If you think that the market forecasts about how future prices might rise or fall are correct, then inflation is probably not going to be a big deal. But if you think the market forecasts are wrong, the outcome will depend on the direction in which you think it will be wrong. For example, if you expect higher inflation rates than the market does, you might consider getting out of pure climate players that are still far from profitable and therefore vulnerable to cost hikes – for example, EV producers like Rivian (NASDAQ: RIVN) or Lucid (NASDAQ: LUCD). Instead, you might build positions in dividend payers, such as transportation companies like Canadian National Railway (TSX:CNR) or Union Pacific (NYSE:UNP). Given that I’m personally invested for the long term – and I doubt that I can predict future inflation rates more accurately than the market – I’ll hold tight with my current investment positions in Pure Climate Stocks.

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