Debt as a hedge againt inflation

8th Septembre 2022, Trends

Investors don’t know where to turn their heads as they fail to identify investments that outpace an inflation rate running at 10%. It is fair to say that stocks are a hedge against inflation because companies can pass on inflation in their selling prices. However, in the short to medium term, stock prices are all over the place. The stock market rose 6% per year during the stagflation of the 1970s, lagging inflation by a wide margin. Gold is often cited as a hedge against high inflation, as it had a stellar performance during that same period, but that was more due to the economic and political chaos of the time than to high inflation. In the short run, gold is primarily a hedge against chaos. Anyone who believes that the current inflationary wave will also go along with chaos can indeed buy gold as protection. Those who don’t believe in chaos better think twice before buying gold, especially when US bond yields – US Treasury bonds remain the world’s safest asset – are rising strongly. And what about digital gold, crypto? Let’s be serious. Crypto is pure speculation and make-belief. A such, it is a hedge against nothing at all.

When central banks keep interest rates artificially low, cash and bonds are disastrous investments in times of high inflation. In the U.S., the central bank is raising short-term interest rates to 4% to slow the overheating economy, but those rates are still far below inflation. The European Central Bank will raise short-term interest rates until they reach 1 to 1.5%, but not much more. After all, higher interest rates will not solve Europe’s inflation problem, which is linked to exorbitant energy prices. The bond market offers no comfort either. The yield on 10-year euro-government bonds is a meagre 2%. Europe, unlike the US, simply cannot afford higher interest rates. Italy, the elephant in the room of the European Monetary Union, has a debt to GDP ratio of 150% (its public debt stands at 3,000 billion euros). Those who invest in cash and bonds face a structural loss of purchasing power. But what if we reverse the situation?

Inflation works in favour of the debtor, especially when the interest rate is lower than the inflation rate. Rather than investing in other people’s debts (i.e. bonds) today, it is better to take on debt yourself. Ideally, the amount borrowed should be invested in a low volatility asset whose value keeps up with inflation. And then you inevitably end up with a residential property in non-speculative markets like Belgium, provided you follow a number of sound principles. The general rule is that a property is considered as new if it is less than ten years old. During this period, the value of the property increases according to the cost of construction, e.g. measured in Belgium by the ABEX index. Since the beginning of 2021, this index has risen a good 11%, identical to general inflation. After 10 years, wear and tear occur and the change in value of the property starts lagging inflation. Therefore, you should opt for extremely energy efficient new housing, especially in an era where energy costs are out of control. In Belgium, rent can legally be indexed to the consumer price index (“health”) index.

Of course, investing in direct residential real estate is not without risk. Those who invest directly rather than through a fund face significant management costs, as well as the risk of under-diversification. The ABEX index can lag headline inflation, a sudden and unexpected rise in interest rates can cause prices to plummet, and vacancy can affect your rental yield, as can the inability to pass on all of the inflation to the tenant. But successful investing is not about avoiding risk. It’s about taking the right risks. In times of high inflation and low interest rates, cheaply financed energy-efficient residential properties offer an attractive risk/reward ratio. And those who don’t care about stock market volatility can eliminate many of these risks by choosing a listed vehicle, which itself uses leverage.