The Best Hedge against Inflation

I probably wrote too many posts about inflation, recently. Writing another one was definitely not my intention; then, yesterday I went running and listened to the latest podcast episode of The Compound and Friends, where Nick Maggiulli echoed a concept I had in my mind for some weeks. My idea might have some legs indeed! So here we are…

The premise

Having a child is a miracle. Growing up you see…you, your siblings, your schoolmates, a world full of kids, that the concept of having children seems part of the norm. Then there is ‘that phase’ when you actually pay (or should) great attention to avoid the possibility of becoming a parent. It is only when you decide to be a father, or a mother, that you discover the actual chances (given the age of the wanna-be father and mother, obviously).

Planning, financials included, when your family will grow is an activity that requires a wide range of outcomes. When you desire more than one child, the volatility of that forecast grows exponentially. I and my wife wanted to have two and our ideal plan included these two considerations:

• they should be close enough, age-wise, to grow together
• we want to minimize the overlap of nursery fees

The second point might drive some people crazy: how would we dare to put such a material consideration on the fate of a human being? Unfortunately, we live in a world where these calculations matter, whatever your ideal vision of how life should be. The nursery cost for two children is higher than the average UK salary, which usually leads to the question: does it make sense that one parent (normally the one that has the lower salary, normally the wife) should continue to work if that salary goes to pay someone else that is looking after your kids? On the other side, a three to four years career break is often a career eraser: deciding to take care of your children will have an impact on your whole career, way beyond those years you took off. It is a complex topic that our society at large still manages closer to The Handmaid’s Tale dystopia than to where we think we are.

My wife is going to deliver our second child in a month, exactly three years after our first daughter was born. Not sure how it happened but somehow we ticked that box where we wanted. Once the doctor told us the due date, it was time to go to the planning board. My wife was working for a start-up that was on the brink of bankruptcy: we might transition from two salaries and two mortgages (the apartment and first kid nursery) to one salary and three mortgages. Or one salary, two mortgages if we would put the kids to the nursery only three days/week.

Anyway, that’s when the inflation catastrophe started to emerge on the horizon and the reason why I began to be so obsessed with it. First, the electricity provider we inherited when we bought the apartment went bye-bye. This event in itself was a great explainer of the real-life consequences of the current ESG-obsession in the investment world. How can an energy provider that is 100% green can go bankrupt because the price of natural gas exploded? Aren’t they producing energy only from wind farms and solar?

The reason is pretty simple, if for one second you take off the ESG-shaded glasses: when the wind stops blowing, your fridge still needs energy. This means your energy provider has to source power somewhere else, and given the mainstream hate for nuclear, that power has to come from nat-gas or oil. If you have a fixed tariff and your provider did not hedge itself…boom: they are going to sell you power at 10 and pay for it at 50. This is the reason why the dream of having 100% renewables is impossible unless you either have a massive amount of generation redundancies between solar, wind and where geography allows hydro plus gigantic batteries or you massively step up your nuclear game.

My mind got monopolized by news about electricity bills that were going to double, even triple and I started to pay attention to every switch in the house. I even contemplated going back to the office more frequently just to save on consumption. After the dreadful electricity cap-rate increase happened, my bill went…down. The only concrete actions I took were to turn off the switch of the tv and the laptops after using them, something that I should have done anyway years ago because it is a real waste of energy. Fact is, how the energy provider estimated my consumptions, where my monthly payment was set and how frequently they checked my meter was way more relevant for a household that does not consume that much energy anyway.

Rule number one: scaring titles work to sell newspapers/attract clicks. Reality is usually not that bad.

While I was scouring our family costs line by line, I came out with this idea:

A High Saving Rate is your Best Hedge against Inflation

If inflation goes up 10%, your salary purchasing power goes down 10%. That’s a fact.

But if you are not spending 100% of your salary every month (I am not referring to “paycheck to paycheck” living here because people that do that normally have no choice, instead there is a lot of people that could save and do not), your loss today is on the amount that you spend.

Let’s use the classic personal finance budget as an example:

• 50% essentials
• 30% leisure
• 20% savings

for a person that earns £1.000/month.

After a 10% inflation shock, the budget for essentials is now £550/month. Here there is (almost, will see later) nothing you can do, those are called ‘essentials’ for a reason. Now this person has two choices: maintain the same level of leisure, now at £330, and cut savings to £120, or maintain savings at £200 and cut leisure to £250.

An important caveat: in the ‘maintain savings’ scenario, the cut on leisure is close to 25% (330 – 80), not 16% (300 – 50), because £250 today does not buy that person the same things that they were a year ago. Losing a quarter of the budget for fun stuff is not easy, unless the initial budget was so high that money was spent just out of boredom instead of ‘necessity’ (yes, we need some fun in life but £2M does not buy double the amount of fun that £1M do, there are diminishing returns).

The main point here is that, if the person arrived prepared for the inflation shock, he now has a choice. He can reduce his savings and his present life would not change a bit. That’s quite powerful, innit? Obviously this choice today will mean he will have less flexibility to future inflation shocks, or that his retirement plan would have to change and more so than in the constant-savings scenario because all the savings stash also lost purchasing power. But he can buy himself time while he looks for a better-paid job: in the end, if he stays on top of his game, his skill ‘price’ should go up with inflation, like any other real asset. At a certain point, someone will pay him again his real (in monetary terms) value with a higher salary.

Real Life examples – Essentials

Rent contributes around 30% to inflation measures around the world (each country has its own basket). If you own your home, you are in charge here. Simply by having a fixed mortgage, you are protected against any movement in the 30% of the inflation basket, not peanuts. In the scenario where you own your place with debt, inflation is actually your friend: in nominal terms, your asset value goes up while debt stays constant and in real terms, the asset is constant while debt value goes down. I have a bad memory but I hardly remember this point mentioned in the standard debate of owning vs renting.

The amount of ‘value’ that a renter is losing depends on the laws of the country where you live. In the UK, is quite common to have rent contracts linked to the inflation index. This is obviously a very bad policy mistake…but what you would expect from the same people that brought you Brexit? Even if you try to model it in Excel, you would get a circular reference error: rent goes up because RPI goes up, but RPI is 30% rents so, once the wheel starts spinning, there is no way to stop it.

The counterpoint that landlords (and Brexiter renters) would make is that if you do not like your rent, you can move out. The issue with that logic is that moving is not as seamless as changing your toilet paper brand. You might have kids at the local school, your office commute might become too long or there might not be any other comparable, in terms of size, alternatives that fit your requirements. Yes, free markets bla bla bla, but I find Switzerland’s policy, where the landlord cannot raise the rent unless they do real improvements to the asset, way better.

Anyway, I think you should consider the possible inflation hedge part when deciding between renting and owning.

Another item in the ‘essentials’ category where you can act is food. My grocery shopping was done on a mid-tier quality delivery-only app called Ocado, mainly out of non-financial convenience considerations: I could find anything in one place and it was delivered in front of our door. For someone that hates shopping and does not own a car, it is a godsend. Now when I have the time (again, convenience), I go to buy some essentials at a discount supermarket, even if the trip back by bus is honestly quite a pain. Same for nappies: I used to buy Pampers because I could find them on Prime and now I use the 30 minutes walk to Lidl as an additional excuse to listen to again another podcast.

What I mean is that a lot of choices we make are a mix of price and convenience; if the value you get is not justified anymore by the price (thank you, inflation), or it becomes a negotiable luxury compared to other non-negotiables, you can save by trading your time for some costs. The fact that I do not own a car falls in the same bucket. It is not that I do not have things to do with it if I had one, its cost is not justified by its utility for me. Had I decided to live in another part of London, or even outside London, I would have needed one…but I could have lowered the apartment costs. Choices that lead to other choices. Fact is, I do not give a crap about the price at the pump. I am not 100% shielded by it, I still take Ubers and planes, but my exposure is definitely low. Inflation is in the eye of the beholder, as SBF recently said on Twitter.

I obviously find it amusing when I see people complaining about the cost of gas and then I see that they drive a huge SUV just to do the daily, 20 minutes, commute from their place to the nursery. That’s your choice dude, just own it.

I live close to Broadway Market, a small street in East London full of…I would have said hipster but I am not sure the definition still exists…shops for ‘overeducated and underpaid people’, as Trader Joe’s founder would put it. I have two favorites here: sandwiches in a French bar-boulangerie for some week lunches and sourdough bread for weekend breakfast. The price of none of those items changed in the last two years. They were not cheap to begin with but still, no inflation there. My theory is that owners might be scared customers would simply cross the street and buy from another store.

Companies can raise prices only if customers continue to buy.

Real Life examples – Leisure

I hear a lot of complaints about hotels and plane tickets prices. Managers of those companies went through hell since 2020, with multiple starts and stops. No kidding their costs went to the moon, imagine the level of flexibility you have to maintain. That said, the only reason you see those prices is because people are paying them. Yes, it sucks if you spent the last two years at home that now it costs a kidney to go to the beach…but that’s how the world works.

The only reason why prices of non-essential categories are up is that people are out and about spending. Maybe they negotiated a better raise than you, maybe they stopped saving, maybe they took debts. For sure, no one booked a trip to the Caribbean because they had to.

Coming to the next recession, and probably we would not have to wait for that much, you will see those prices retrace again. This is the part of inflation Central Banks can control and they control it by removing the punchbowl and stopping the party. CBs cannot do anything about supply-side disruption but they can, and will, choke demand. The issue won’t be the restaurant price anymore, it will be how can you make sure you will still have a salary by then.

Conclusion

A sound investment strategy should protect, at least in the long term, your savings from inflation. In the short term, inflation bites on your current level of spending. This is why having a low saving rate not only affects your retirement prospects, it increases your exposure to inflation shocks. Having a firm control over your spending increases your optionality in periods like the one we live on right now.

What I am reading now:

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