By Alexander Jones, International Banker
With the grim spectre of inflation returning over the last year to unleash crippling cost-of-living crises across much of the world, central banks have proven largely powerless to rein in runaway prices thus far. Inflation continues to creep higher, which means the purchasing power of money in many countries continues to be significantly eroded.
Investors must thus protect themselves against this attack on purchasing power by identifying those investments that offer the most effective hedges against inflation. Such investments typically maintain or increase their values during spiraling price growth, thus preventing substantial portfolio losses.
Among the most effective hedges against inflation are Treasury inflation-protected securities (TIPS)—US Treasury bonds backed by the US government that are structured to protect against changes in the Consumer Price Index (CPI). As inflation rises, TIPS increase in value, usually through an increase in interest paid to bondholders. This means they may even outperform other government bonds during periods of pronounced inflation.
And because the US government backs them, TIPS are among the safest investments in the world from a credit-risk perspective. They tend to pay interest to investors twice a year and are typically issued at maturities of 5 years, 10 years and 30 years.
Investors can also purchase TIPS easily via exchange-traded funds (ETFs) and mutual funds.
Historically regarded as safe-haven assets, their prices tend to be uncorrelated or weakly correlated with those of more traditional asset classes, such as stocks and bonds; precious metals, including gold, silver, platinum and palladium, typically retain their values during periods of elevated uncertainty in the market.
Historically, this has largely been the case because precious metals are impervious to changes in macroeconomic policies such as interest-rate hikes, as well as other factors that could trigger inflation. And given their fixed, finite physical supplies, precious metals do not lose value on the back of more money being printed, as has been the case during the pandemic—a period that has seen trillions of dollars being pumped into the global economy through quantitative-easing programmes, a policy that has undoubtedly contributed to this ongoing bout of inflation.
In an in-depth piece written for Reuters published in early February, the World Gold Council (WGC) argued that while gold’s effectiveness as a hedge against inflation in the short term is questionable, it has a proven track record over longer, multi-year or multi-decade horizons. “In the long term, gold serves as a strong strategic component in many portfolios, not only for its diversification benefits but also for its returns,” the WGC’s research concluded. “The relationship gold is shown to have with money supply demonstrates, perhaps, that the strong returns we have experienced since 1971 are not aberrant. Gold’s ability to protect against more than increases in the general price level suggests that its long-term real returns should be positive—something current long-term portfolios may struggle to achieve.”
Given its wider industrial usage, moreover, silver may be an even more effective hedge against inflation than gold, according to Morgan Stanley. “Historically, both gold and silver have made solid gains when US inflation is rising, in part because the increased costs of goods and services often coincides with a weaker US dollar,” the US bank explained on its website in September 2021. “Both metals are valued in US dollars, so when the dollar falls in value, gold and silver typically rise because they become less expensive to buy using other currencies. Given greater industrial demand, silver tends to rise more than gold with rising inflation and a falling dollar.”
While not all stocks act as effective inflation hedges, those that pay dividends provide investors with crucial periodic cash flows that can protect purchasing power. That said, such stocks should ideally demonstrate strong growth profiles that can enable rising dividend rates in the future, continuing to protect investors against rising inflation.
Stocks in cyclical sectors can also offer protection against rising inflation, although this would typically be more effective when inflation emerges due to an environment of strong economic growth. “Today’s best hedge is arguably one of the simplest: cyclical equities able to maintain pricing power,” Russ Koesterich, a portfolio manager for BlackRock, explained in November 2021. “While gold has not kept up with rising inflation expectations, many cyclical industries—including energy, materials and select consumer names—have.”
As with stocks, not all bonds offer sound protection against inflation; long-term fixed-rate bonds, for instance, offer bondholders constant coupon payments that can expose investors by failing to rise when inflation is on the rise. The yields on floating-rate bonds, on the other hand, do rise.
A floating-rate bond allows the coupon payment to rise when interest rates go up, which, in turn, happens invariably when inflation rises (as is presently the case). Typically, the coupon rate is based on a reference rate, such as the Federal Reserve’s benchmark federal funds rate or the London Inter-Bank Offered Rate (LIBOR), plus an additional spread. It then changes in response to swings in these reference rates. And with rates expected to continue rising this year as central banks struggle to rein in inflation, floating-rate bonds will offer increasing coupon rates to investors, thus keeping them well shielded from rising prices.
Investors can normally purchase specific floating-rate bonds via brokers or buy ETFs that hold floating-rate bonds, such as the iShares Floating Rate Note Fund and the VanEck Market Vectors Investment Grade Floating Rate Bond ETF.
Homeownership can be a highly useful hedge against rising prices in several key ways. For one, purchasing a home via a fixed-rate mortgage will allow the homeowner to make constant repayments every month despite the environment of rising prices. While other property expenses may rise, at least the monthly housing payment will remain constant, which is a distinct advantage during periods of rising prices.
Raw property values also increase during periods of high inflation. As both a homeowner and landlord, this provides a suitable hedge against rising prices, as one can sell the property at a higher price or boost rental income if leasing the property out to tenants. And as a homeowner rather than a tenant, the investor no longer has to be concerned about rising rents during periods of high inflation.
Investing in REITs (real estate investment trusts) is an alternative option to outright home ownership and can be accomplished conveniently through mutual funds or ETFs. A REIT normally takes the form of a publicly traded company that pools investors’ funds together to invest in income-generating commercial or residential real estate. Investors then earn dividends generated from real estate without having to buy or operate the properties themselves.
“REIT dividends have outpaced inflation as measured by the Consumer Price Index in all but two of the last twenty years,” according to the National Association of Real Estate Investment Trusts (NAREIT). Perhaps unsurprisingly, those two years were during the global financial crisis in 2009 and during the pandemic in 2020. On both occasions, dividends were cut to marginally less than the inflation rate.
But between 2000 and 2020, NAREIT found that the average annual growth of dividends per share for REITs was 9.4 percent (or 8.4 percent compounded) compared to only 2.1 percent (2.0 percent compounded) for consumer prices. “REITs provide natural protection against inflation. Real estate rents and values tend to increase when prices do. This supports REIT dividend growth and provides a reliable stream of income even during inflationary periods.”
A distinctly broad asset class, commodities include energy products such as oil, gas and coal; metals including copper and aluminium; and agricultural products such as soybeans, coffee and orange juice. Normally, rises in commodity prices indicate strong demand, which can result in high inflation. As such, the values of commodities tend to swell when inflation does, thus providing a good hedge against rising price levels.
On this occasion, for example, the rise in global prices is partly reflective of the surge in energy prices. With popular crude-oil benchmarks still around the $100-per-barrel mark, those who purchased oil futures last year would have been shielded from the losses in purchasing power inflicted by the high inflation rates that continue to plague the global economy.
A similar relationship has also materialised with soaring food prices. Again, the purchase of wheat futures may have helped protect investors against the ongoing wheat-price appreciation that has arisen mainly as a result of the conflict in Eastern Europe.
That said, commodities can exhibit pronounced price volatility. Nonetheless, for a broad-based exposure to commodities, investors may want to consider a fund such as the iShares S&P GSCI Commodity-Indexed Trust (GSG).