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How to Position a Portfolio for Rising Inflation | Hedge against Inflation with BMO ETFs 2022

Updated: Nov 14, 2022

We all have heard of inflation going out of control in recent headlines. You may have thought that there is nothing you can really do about it. At the same time, you may have experienced the real effects of inflation in your everyday life as prices for basic things like groceries and gas have started to increase while your income hasn’t really changed. Today, I will be covering basics of inflation and current market conditions, how it directly affects you, and investments that tend to do well to hedge against inflation.

Inflation 101 & Current Market Update

Inflation is the decline of purchasing power of a given currency over time. This means that the Canadian dollar is worth less today than it was a couple of years ago. In fact, according to a study released by Bank of Canada, the Canadian dollar lost more than 94% of its value between 1914 and 2005, and probably a lot more given its 2022! To put this into perspective, one dollar in 1914 would have the purchasing power of $17.75 in 2005 dollars. It is estimated that a dollar will lose half of its purchasing power in approximately 35 years.

To further put into perspective how the value of the dollar has changed over time, let's take a look at the cost of stapes, such as food. If we take a look at the cost of beef per pound, in 1900 it was 14 cents whereas in 2005 it was $6.99. That is almost 5000% increase!

You can see in this chart here that the dollar is losing purchasing power at a dramatic decline, and it's expected to accelerate in the next few months if inflation is not reined in by the Bank of Canada. In fact, the Bank of Canada and the US Federal Reserve both stated in 2021 that they will allow inflation to run beyond the 2% target that they have been maintaining, with no hard ceiling specified.

Now, how the Bank of Canada keeps track of inflaton is via the Consumer Price Index (CPI), which represents changes in prices as experienced by Canadian consumers. It measures price change by comparing, through time, the cost of a fixed basket of approximately 700 goods and services, which are divided into 8 major components: Food; Shelter; Household operations, furnishings and equipment; Clothing and footwear; Transportation; Health and personal care; Recreation, education and reading, and Alcoholic beverages, tobacco products and recreational cannabis.

We are able to measure CPI by comparing the purchasing power of comparable basket of goods and services over time. For example, if a basket of goods and services were purchased in 1914 for $100, a comparative basket would now cost about $2364 in 2021.

You may be wondering how inflation now compares to the past few years. You can see here that inflation hasn't been this high since 2003, which is19 years ago. While we've been told that inflation is transitory by the authorities, it appears unlikely it will settle down any time soon and there is a high chance that inflation will continue to be above 2% as the Pandemic continues and lockdowns are still a thing, even as recently as January 2022. Per Bank of Canada:

The average inflation rate of goods in 2021 has been 4.4 percent—much higher than that of services, which has been 2.1 percent. In the 20 years before the pandemic, goods inflation averaged only 1.4 percent.

A combination of factors collided that have squeezed inflation to go rampant and have put upward pressure on prices. First, printed stimulus money that flooded into the economy during 2020 & 2021 are at historic levels. This means that households have more money to spend on goods - and at the same time, amount of goods hasn't changed. This alone would increase the prices of goods as there are more demand. To make matters worse, there are actually shortages of certain goods and they are becoming more expensive to produce as there are supply chain disruptions that has delayed shipping, energy price increases as the economy reopens, and shortage of workforces that have both delayed production and increased input costs as wages have increased to incentivize frontline workers.

The full effects of the pandemic on the economy has yet to show, and there is a high likelihood that there are going to be some rough patches ahead.

So What & How does this affect Me?

Inflation has been managed by the Bank of Canada and maintained on average of 2% per year through fiscal policies. However, inflation has now averaged 4.7% in 2021 with salary not really keeping pace. In December 2021, the CPI for Canada was up 4.8% and the US showed 7%, which indicates that despite CPI being a backward looking metric, the numbers have been rising consistently throughout the year. The current market outlook for annual inflation is about 3% for the next five years, which is above the initial inflation target of 2%.

Note: The most recent CPI report show 5.1% for January 2022 and 5.7% for February 2022, which shows an increasing trend from December 2021 CPI results of 4.8%.

You may have noticed it has become more difficult to buy certain items, such as cars and computer hardware and chips - pushing up the prices significantly. Even your everyday goods and services, such as your grocery bills or eating out at a restaurant seem to have gotten more expensive. This is because some businesses are suffering from the previously mentioned factors of supply chain issues, energy price increases, and shortage of workers, on top of increased costs related to Covid-19 related expenses such as investing in PPE, sanitary requirements, and increased wages for front line workers. Ultimately, these costs are pushed forward to consumers, such as you and me.

Inflation is pervasive and it's important to be proactive with your money so it doesn't get eaten away by inflation. If you just have cash sitting in your bank account, earning at best 0.5% with policy interest rates at an all time low of 0.25%, cash is essentially eroding away as inflation rates are growing (ie. an average of 4.7% in 2021). That is a lot of numbers, but you can clearly see that something is simply not adding up. So what can you do with your cash instead?

One of the best ways to at least have your cash afloat with increasing inflation is to invest it. Fixed Income investments such as bond yields are low risk but a 5 year Government of Canada bond provides a measly yield of 1.5%, which is above a bank's savings account of 0.5% but below inflation of 2 to 4%. Equities such as stocks tend to do a better job of protecting against inflation than fixed income, as you can potentially benefit from the value of your investment increasing while receiving payouts. Let me explain.

As a customer, you are suffering from price increases as a company pushes those costs to you. On the flip side as an investor, you can potentially keep up with inflation as company's aim to keep up their profits and relay on shareholder benefits to you if stocks appreciate in value and though dividend payments. However, there are certain asset classes that actually hedge better than others, which we will be discussing next!

So How Do I Hedge Against Inflation?

I will be discussing some equity asset classes that protect against inflation, such as high quality blue chip companies, oil and gas, infrastructure - and stay until the very end as I will be going into depth my personal favourite - REITs.

I will be talking about Inflation Investing via investing in ETFs. I've personally invested and mentioned BMO ETFs in past blog posts, as they offer some of the most comprehensive and low cost ETFs in Canada and have been around since 2009. BMO ETFs are made in Canada for Canadians with over 26% market share in the Canadian ETF space, and can be found on any self-directed online brokerage. That is why I'm excited to be partnering with BMO and want to thank BMO for sponsoring this part of the blog post. Free feel to visit BMO ETFs to take a look through all of BMO ETFs that are available to suit your investing needs.

Hedge #1: High Quality, blue chip companies as they are more resilient to inflation as they have better pricing power and will have an easier time passing on higher input costs to end consumers. They also tend to have healthier financials and lower debt, which will be less of a burden on interest payments when rates rise. BMO's MSCI USA High Quality Index ETF, ZUQ, provides exposure to these type of companies. Though if you are a fan of S&P 500 index ETFs, then it will also cover a lot of these large cap companies.

Hedge #2: Commodities such as oil and gas are also a hedge against inflation as they are priced in real terms. With the economy reopening and supply imbalances, there has been a sharp demand for oil and gas. BMO's Equal Weight Oil & Gas Index ETF, ZEO provides exposure to Canadian energy sector. Thought keep in mind oil and gas investments can do well but also tend to be volatile.

Hedge #3: Infrastructure also holds up well when inflation rises, as some of these companies even index their revenues to inflation and have long-term government contracts. You may have heard of the US spending $1.2 Trillion on infrastructure with Biden's bill passed and the Government of Canada committing to spend $180 Billion on Infrastructure for the next 12 years which started in 2016. BMO's Global Infrastructure Index ETF, ZGI provides exposure to infrastructure companies.

Hedge #4: Real estate is my my personal favourite and the investment I will be focusing on as a hedge for inflation . Like physical goods, real estate is considered a hard asset, something that is tangible, and property values tend to increase during inflationary periods. In addition, commercial and office spaces can potentially benefit as the economy continues to open up and when people return to offices. Now going out to buy real estate properties tend to be too expensive and too big of a commitment for many people. Instead, the easier way to invest in Real Estate and according to your financial situation is through Real Estate Investment Trusts, aka REITs. REITs are companies that own or finance real estate properties and earn rental income. REITs are required to meet many requirements to qualify as REITs and to be listed on the stock market; in addition, they are required to pay out at least 90% of their taxable income to shareholders.

In inflationary times, not only can REITs appreciate in value if real estate prices continue to increase, but they can also provide decent payouts to you as a investor in the form of dividends. BMO's Equal weight REITs Index ETF, ZRE is composed of various real estate investments in Canada.

To give you some more details and stats on the ETF, the market price is around $27.44 per share as of March 9, 2022, which is a very reasonable entry point. The benchmark is against the Solactive Equal Weight Canada REIT Index. ZRE had a return of 34.02% in 2021, which beat the S&P 500. It’s 3 year average return is 10.90% as of Feb 28, 2022 (keeping in mind 2020 experienced negative returns of 7.69% due to the start of the Pandemic). Remember that past performance is not an indicator of future returns!

My favourite part of this REIT are the dividends, which are paid out on a monthly basis with an annualized yield of 3.95% as of February 28, 2022! This REIT provides broad exposure to the Canadian REIT universe, instead of just focusing on residential and office spaces. As you can see in the sector allocations, there is a good mix of retail, residential, industrial, office, and health care - and consists of 22 top Canadian REITs with Total Net Assets of $813M. Lastly, the management fee is 0.55%, which is comparable to other Canadian REIT ETFs and might actually be on the low end.

If you want to do your own research on REIT ETFs or other ETFs for that matter, BMO has a great comparison tool which I will be linking here for you to check out.

Market Cap Weighted (XRE) vs. Equal Weighted (ZRE) ETF

I’ve previously mentioned in my Dividend ETF blog post here that I’m investing in XRE, but I’m able to see that investing in ZRE provides further diversification to my portfolio. XRE and ZRE are two Canadian REIT ETFs from the two largest providers in Canada. The main difference between the two ETFs is that XRE is market cap weighted and ZRE is equal weighted. The benefit of an equal weighted method is that it avoids concentration risk of a single stock.

As you can see in XRE’s holdings below, Canadian Apartment Properties and Riocan make up almost 25% of the entire portfolio, which presents concentration risk. On the other hand, as you can see in ZRE’s holdings below, there is more diversification in equal weight, as there is no single REIT that takes up more than 6% of the portfolio, with the greatest holding being Boardwalk at 5.98%

On the other hand, as you can see in ZRE’s holdings below, there is more diversification in equal weight, as a single REIT takes up ~6% of the portfolio, with the greatest holding being Dream Office at 6.21% and Boardwalk at 6.00%.

And because I value diversification and want to add more real estate to my portfolio and hedge against inflation at the same time, I’m also investing in ZRE. Please do your own research and determine what’s best for you for your unique investment profile.

If you want to learn more BMO's ETFs, you can check out the following links:

➡️ BMO Equal Weight REITS Index ETF (ZRE)


➡️ BMO's Fund comparison tool for research


Disclaimer: Note this post is not financial advice and should be used for entertainment purposes only. Please do your own research and/or consult with your own financial advisor before investing your own money.

*This blog is sponsored by BMO ETFs, but all views and opinions expressed are my own and are based on my own research of the subject matter.*

#bmo #ad #etfs #investing #investingcanada #inflationinvesting #rrsp #tfsa


This blog is sponsored by BMO Global Asset Management

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