Accelerating inflation is increasingly affecting the global economy and financial markets. In November 2021, inflation in the U.S. reached 6.8%, the highest in 39 years.
The main contributor to this acceleration was the growing energy price due to a supply shortage and crisis in that market. Inflation is rising because of supply chain disruptions caused by the pandemic and a simultaneous increase in consumption, experts say.
However, keeping inflation-hedged assets to protect your capital from depreciation is not as difficult as it seems. Let's discuss this phenomenon in more detail and talk about the most effective ways to hedge against inflation.
The article covers the following subjects:
Defining Inflation
Inflation is a rise in the general price level of goods and services. In inflation, the price of identical goods increases over time. For the same amount of money, in time, you can pay for fewer goods and services than before. In essence, the purchasing power of money is reduced, money is devalued.
The depreciation of money leads to rising prices in a market economy. In an administrative-command economic system, the depreciation of money may not lead to a change in prices, but there will be a growing shortage of goods.
Inflation as a long-term, sustained process should be distinguished from a one-time increase in prices (due to monetary reform or a political event). Inflation does not mean a simultaneous increase in all prices in the economy because the prices of individual goods and services can go down or remain unchanged. It is important that the overall price level, the GDP deflator, changes.
Negative Impact of Inflation and Risks for Investors
Low inflation is usually considered a necessary phenomenon for a healthy economy: a small and predictable decrease in the purchasing power of money encourages economic agents to spend and invest or save. Too low or too high inflation is perceived as negative for the economy, so the monetary authorities, the central banks, try to keep the annual inflation rate at a reasonable level of between 2-4%. Such a rate prevents the negative impacts and risks, meaning we can refer to it as good inflation. Too low inflation is harmful to aggregate demand, production, and investment, which are the fuel of economic growth.
Any investment that yields a fixed rate of return or interest will get a lower return in real dollars in an inflationary environment. So while inflation affects all investors, it is especially difficult for income-oriented investors.
Too high inflation significantly increases uncertainty for consumers and investors alike. High uncertainty, in its turn, means excessive risk-taking and, as a result, less opportunity to spend and invest.
What Are the Best Ways to Hedge Against Inflation?
Given the variety of inflationary scenarios, investors need to learn how to navigate these conditions. It is important to choose the right assets to invest in, taking into account the growth or decline in the purchasing power of money. Keep in mind that there is no universal way to avoid the negative impact of this economic factor. However, let’s review the top ways to hedge against inflation that are considered most effective.
Precious Metals
Gold is the most valuable and sought-after safe-haven commodity in the world. It is a kind of benchmark for financial evaluation. It also determines the amount of reserves of any country.
The dynamics of gold prices can vary depending on various factors — investment demand, economic stability, public holidays, and even natural disasters. When the economy strengthens, gold prices decline.
In times of crisis or market uncertainties, many people see this precious metal as a profitable investment instrument and inflation hedge, so gold prices rise.
A simple deposit in precious metals will not only help preserve long-term capital but also multiply it. It makes no sense to buy gold jewelry because later, you will not get any returns on it. Do not rush to buy physical gold, which is subject to capital gains tax. Banks offer affordable and favorable terms for depersonalized metal accounts. You open an account with a certain amount. The money is then converted into gold, according to the current exchange rate.
The opportunity to save by purchasing precious metals grows with the increase in the investment term. The optimal investment period is 3-5 years.
Other Commodities
Commodities are another good inflation hedge. These are oil, natural gas, precious metals, wheat, and corn. They can be traded on the futures market, where commodity futures contracts are bought and then sold at a certain time in the future.
Commodities naturally protect investors from inflation. As inflationary pressures drive prices higher, commodity prices will also rise later, and investors can make good profits on these investments. Prices tend to move in line with rising inflation, so investors will see the growth that will match the rising cost of goods and services.
Given that the commodities market is characterized by some volatility, experts recommend investing in raw materials through a diversified investment vehicle, such as an exchange-traded fund or mutual fund.
60/40 Rule and Diversification of Your Portfolio
Historically, investors have been advised to split their assets between stocks and bonds as a good hedge against inflation. The recommended ratio varies from investor to investor, but the most popular one is 60/40, according to which 60% goes into stocks, and 40% goes into bonds.
The idea behind this split is the low correlation between these financial instruments. When one asset falls, the price of the other stays in place or rises and so compensates for the fall in the first asset. Stocks are known for price appreciation and provide a high total return, while bonds generate regular income and reduce portfolio volatility. By mixing the two together, you get better risk-adjusted returns in comparison with investments in one or the other.
REITs as a Safe Option for Investing
One of the best options that can serve as anti-inflation assets are real estate investment trusts (REITs). These are publicly traded investment trusts that own a huge portfolio of real estate. Such funds own commercial, residential, specialized, and other real estate types.
REITs are a good solution for investors who want a stable income since the funds pay dividends on an ongoing basis. Equity REIT funds protect investors when inflation rises by recalculating rent payments depending on currency depreciation and price increases. The built-in mechanisms of recalculation in commercial real estate give a stable yield through dividend payments.
S&P 500 Potential
Stocks offer the greatest growth potential over the long term. In general, a rise in inflation benefits those businesses that require little capital, while natural resource businesses lose out to inflation.
The S&P 500 currently has a high concentration of technology companies and communications services: their stake in the index is 35%. The index is one of the main investment instruments that has existed for a long time. It gives the opportunity to invest in the largest companies traded on the U.S. stock exchanges. Since the index includes 500 of the biggest public companies, the volatility of some stocks doesn’t affect the index much.
Real Estate as a Steady Income
Being a tangible asset, real estate is the easiest way to invest.
It’s most profitable to invest in new buildings at the design stage. In this case, the investor can count on the maximum income, especially for elite residential complexes in major cities. As for the secondary market, you can buy several one-bedroom apartments and rent them out. This is the easiest way to save and grow your money.
Using such strategies and investments to hedge, you will protect your savings and provide a steady monthly income.
Bloomberg Barclays Aggregate Bond Index
The Bloomberg Barclays Aggregate Bond Index is an index that evaluates the U.S. bond market. There are five types of securities the index includes: government, municipal, and corporate bonds, mortgage-backed, and asset-backed securities. The best way to invest in this index is to invest in funds whose goal is to reproduce the index levels.
Keep in mind that this index is weighted on the opposite principle from the S&P 500 Index, which is weighted by market capitalization (the larger the company, the higher its rank in the index). Companies and institutions with the largest debts are the largest components of the Bloomberg Barclays U.S. Aggregate Bond Index. For this reason, it is not always well diversified across company market sectors.
Collateralized Loan Obligations
A leveraged loan is a loan that is made to companies with high levels of debt and poor credit history. Because these loans have a very high risk of default, they cost the borrower more than conventional loans.
As an asset class, leveraged loans are commonly referred to as collateralized loan obligations (CLOs), which include multiple loans bundled into a single security. While the underlying loans bring scheduled debt payments to the investor, CLOs typically have a floating rate of repayment. When the key consumer interest rates increase, so do interest rates on leveraged loans. They adjust and lose value much less than many fixed-income investments in times of inflation and interest rates rise. It is the rate that makes leveraged loans an excellent inflation-hedged asset.
TIPS As Protection from Inflation
Treasury Inflation-Protected Securities, known as TIPS, are debt securities issued by the U.S. government. They are a type of Treasury bond, but unlike conventional Treasuries, TIPS are anti-inflation assets.
These bonds are issued to protect an investor's capital from depreciation in a highly inflationary environment. The bond's par price and payments increase according to rising consumer prices and thus retain their true value.
Depending on the type of TIPS, they reach full maturity in 5, 10, or 30 years. Payments on such bonds are based on a percentage of the inflation-adjusted principal or the value of the bond and are made every half a year. The face value of the bond is indexed twice a year according to the official inflation rate in the U.S., which is referred to as the Consumer Price Index. As the face value rises, the payment also rises, as it counts as a percentage of the face value.
iShares TIPS Bond ETF
The iShares TIPS Bond Fund is an ETF that tracks a market-weighted index of U.S. Treasury securities protected against inflation. It matures in at least one year.
The fund follows the Barclays U.S. TIPS Index (Series-L). The index measures the dynamics of the yield to maturity of TIPS. The fund invests over 90% of its assets in index inflation-protected bonds in proportion to their weights in the index so that the fund's return, excluding management fees and other expenses, coincides with the return on the underlying index.
Launched in late 2003, the fund had the advantage of three and a half years to accumulate assets before its first competitor came along. This ETF has a broad and diversified portfolio.
The iShares TIPS Bond ETF has an MSCI ESG fund rating of 6.58 out of 10. The rating of the MSCI ESG fund measures portfolios' resilience to long-term risks and potential environmental, social, and governmental management issues.
Schwab US TIPS ETF
This ETF offers broad access to TIPS, bonds issued by the U.S. government, with a principal amount that adjusts based on certain inflation indicators. Thus, SCHP can be attractive as a small allocation in a long-term portfolio with increased weighting if investors are particularly concerned about keeping inflation-hedged assets.
This fund is very competitive from a cost perspective but not as liquid as some other funds in this category. However, its excellent expense ratio should more than compensate investors for this disadvantage, making SCHP a worthy choice for any investors looking to enter this corner of the bond market.
While TIPS have become popular assets for inflation-protected investments, it should be noted that there are potential limitations for this asset class in achieving that goal. Short-term TIPS ETFs such as STIP or STPZ could be the subject of closer scrutiny, as well as more creative alternatives such as CPI or other alternative ETFs.
FlexShares iBoxx 3-Year Target Duration TIPS ETF
The FlexShares iBoxx 3-Year Target Duration TIPS Index Fund (TDTT) offers access to short-term TIPS; bonds issued by the U.S. government with a principle that adjusts for certain inflation indicators. TDTT can be useful as a tool to protect portfolios from expected spikes in inflationary pressures.
TDTT can be used in moderation by "buy-and-hold" investors or as a tactical play for those who want to move into low-risk assets that can hold up well to inflation.
TDTT tends to underperform on current returns. Given that it features securities that are relatively close to maturity and have minimal credit risk, it is more appropriate as a no-risk instrument for those expecting chaos in the markets. There are some potential drawbacks to using products such as TDTT to hedge against a rising CPI. But for those who want to use inflation-protected bonds in this capacity, funds that buy shorter-term TIPS may be a better choice than those that invest in longer-term securities. By minimizing interest rate risk, investors can reduce potential losses if interest rates begin to rise, a scenario that often accompanies a spike in inflation.
Cryptocurrencies
One of the inflation-hedge tools may be reliable cryptocurrencies like Bitcoin and Ethereum. Though cryptocurrencies are a quite new type of market and didn’t have a chance to perform in times of high inflation, their large capitalization is likely to supply the market in such an environment.
Closing Remarks
Investing during inflation is necessary to protect your wealth. Otherwise it can eat away at your savings. And while keeping some cash on hand is great for financial security, it's best not to keep too much. Over time, you'll find that your money has depreciated.
Instead, plan for inflation by making your money work for you. Choose an investment strategy that is likely to earn you an income at least at the rate of inflation. It’s important to become a disciplined investor cultivating assets that appreciate, have their own fundamental value, or that pay interest at a floating rate.
By keeping up with inflation, you can maintain the value of your money or even generate income.
Trading is an additional opportunity to profit even in times of rising inflation. LiteFinance allows trading most of the assets we mentioned above via contracts for difference.
Hedging Against Inflation FAQs
Inflation scenarios can be many and various. An investor must be well-versed in these processes, choosing asset classes and the assets themselves at any given period of inflation - rising or falling. Keep in mind instruments that will tend to rise in value due to inflation adjustment. And in no event keep too much money in cash.
Diversify your portfolio. Look for assets that have their own fundamental value, such as commodities, those that pay interest like REITs, or have a floating rate like CLOs. As the saying goes, don't put all your eggs in one basket.
Gold is a tangible commodity, which means that it must increase in value at the same time as inflation increases. It becomes especially expensive in times of crisis. Keep in mind that the ability to preserve savings by purchasing precious metals increases with the term of the investment.
Commodities like oil and gas naturally protect investors from inflation. As inflationary pressures drive prices higher, commodity prices will also rise later, and investors can make good profits on these investments. Consider exchange-traded funds or mutual funds for investing in oil and other commodities.
Utility stocks are a good way to protect against inflation, at least because they produce dividend yields. The higher the inflation, the higher the rates on other yield-oriented investments. That causes the price of utility stocks to fall, and that increases returns.
Over the past 50 years, investors have seen the price of gold and other natural resources soar, and the stock market plummet in years of high inflation. Since the price of commodities is measured in currencies when high inflation causes prices to rise and the purchasing power of paper currencies to decline, the value of commodities often rises. However, it is worth taking into account macroeconomic factors, political stability, and competition from investment alternatives.
In terms of hyperinflation, several asset classes will look most attractive to investors. Those are companies in the consumer sector, whose revenues grow in proportion to inflation, banks, gold and gold mining companies, which are traditional defensive assets in a period of high inflation, and bonds, whose yields are indexed to inflation.
In times of hyperinflation, consider dividend stocks. You can buy them quite cheaply, and then when the market grows, the dividends you will receive will be very high relative to the purchase price, and you will get, for example, 15-20-25% of the dividends relative to the purchased value of the shares. Also, consider adding inflation-hedged assets to your portfolio, for example, large companies’ stocks. Such companies are mostly guaranteed to recover after the collapse, and you do not have to worry that you will lose money; besides, they do not fall in price as much as growth stocks. Companies pay stable dividends at all times. Walmart, CocaCola, UnitedHealth, Visa, Pfizer, and many other companies have already established themselves as stable and reliable companies.
The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteFinance broker. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2014/65/EU.
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