How to Hedge Against Inflation
Have you ever noticed that, as time goes by, your money doesn’t seem to go as far? You are not imagining it, ten pounds today does not buy you the same amount as it would have 20 years ago. This is due to inflation, which, although may sound bad, is a perfectly normal phenomenon.
In fact, a certain amount of inflation is actually desirable in a healthy economy. But when inflation gets out of control, it can start to put your hard-earned money at risk. This is why many investors choose to hedge against inflation. But what is a hedge against inflation? And what is the best inflation hedge? In this article, we will look at these questions as well as demonstrate how to hedge against inflation.
Table of Contents
What Is Inflation?
Inflation is the rate at which the price of goods and services rise over a period of time and, consequently, the rate at which a currency loses its value, or purchasing power.
Naturally a currency losing its purchasing power sounds like a terrible thing, particularly for consumers. However, most developed economies actually target a low, stable rate of inflation of around 2%, as it encourages a certain amount of spending over saving which, in turn, helps boost economic activity.
It is also seen as far preferable to the alternative of deflation, where prices decrease and a currency’s purchasing power increases. This, despite sounding good on the surface, can lead to an unproductive economy, as consumers are less willing to part with their money.
What Is Hedging Against Inflation?
Hedging is a method used in the financial markets by traders and investors in order to mitigate risk. This is typically done by opening an opposing position in the market in order to offset any loss incurred in the main position.
A simple way to think of hedging is as an insurance policy, which you might choose to take out in order to protect yourself against an adverse market movement.
But what does this have to do with inflation? What is hedging against inflation?
Inflation hedging involves protecting your capital against inflation’s devaluing effect. Therefore, in order to successfully hedge against inflation, investors need to find assets which will rise in value in tandem with, or at a faster rate than, inflation.
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Why Is Inflation Hedging Important?
When inflation is lower than, or the same value as, interest rates, inflation does not pose a significant danger to savers. When this is the case, the rate at which your savings are losing value due to inflation is being offset by the interest you are earning for storing your money in the bank.
However, problems arise when inflation begins to outstrip the interest rate. When this happens, money which is sitting in the bank loses purchasing power with every day that passes.
This is a situation that many countries around the world find themselves in. Although inflation appears to have peaked in many places, it remains high historically and, despite rising interest rates, inflation is higher in many of these places.
Therefore, now, more than ever, it is important for investors to hedge against inflation. But what are the best ways to protect yourself against inflation?
How to Hedge Against Inflation
So, how can you effectively hedge against inflation? We will now introduce what are typically considered some of the best inflation hedge investments.
Commodities are one such asset class which can potentially be used as an inflation hedge.
Commodities are the building blocks for other goods and services, so it follows that when these goods and services rise in price, the price of the commodities used to produce them will also rise.
Naturally, for logistical reasons such as storage, it is impractical for investors to use commodities as an inflation hedge by purchasing the physical assets. This is why financial derivative products, such as Contracts For Difference (CFDs) can be a useful tool for investors hoping to hedge against inflation using commodities.
However, investors considering using commodities as an inflation hedge will need to consider the fact that commodity prices can be very volatile. Due to the fact that commodities can generally only be produced in certain parts of the world, their prices are very sensitive to factors such as geopolitical events and weather.
There is one particular commodity, however, which is considered by many to be the best hedge against inflation.
Forgive the pun, but when it comes to hedging against inflation, gold is viewed by many as the gold standard.
Gold is considered to be a safe-haven asset – which means that during periods of economic turmoil or periods of high inflation, many flock to this precious metal, increasing demand and pushing up price.
However, whilst gold is considered by many as a hedge against inflation, and there may be some statistics out there which support this view, it is far from the most reliable inflation hedge. We don’t have to travel too far back in time to observe evidence of this unreliability.
Despite inflation reaching its highest levels in decades during 2022, gold prices actually spent much of the year in decline, falling around 20% between March and November. Subsequently, gold prices have gone on a rally, which has seen the precious metal recoup the vast majority of its losses over this period. However, this rally has coincided with cooling inflation in many economies.
Together with gold, other precious metals such as silver and platinum are also viewed as safe-haven assets and, therefore, are considered by some as good inflation hedge assets.
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Property Inflation Hedge
The property market has historically proven to be a reliable way to hedge against inflation. In periods of increased inflation, not only do property prices tend to rise, but so too does the rent which landlords charge their tenants.
Investing in physical property does require a substantial minimum investment, however, there are alternatives available for investors such as Real Estate Investment Trusts (REITs) and property ETFs (Exchange-Traded Funds).
REITs are publicly traded companies which pool investor money in order to purchase income generating properties, such as apartment or office buildings. Furthermore, REITs are obliged to pay out 90% of their taxable income as dividends, which makes them an attractive option for income investing as well.
A well-diversified portfolio of stocks is often viewed as a good inflation hedge over the long-term. However, not all stocks perform well during periods of high inflation. Naturally, in order to effectively hedge against inflation, you need to find stocks in companies which are experiencing a higher rate of return than the rate of inflation.
Certain stocks in certain industries can achieve this. One option would be to buy shares in companies which are engaged in the industries we have looked at already in this article. For example, with respect to gold and other commodities, you could look at the possibility of buying shares in mining companies.
Other stocks to look for in order to hedge against inflation are those which are able to weather economic turmoil without losing demand for their goods or services. For example, companies which provide consumer staples – everyday goods which people need – fit this bill. Consumer staple products tend to have inelastic demand – meaning that consumers will keep purchasing them regardless of their financial situation.
Some examples of companies which provide staple goods are Unilever, British American Tobacco, Diageo and Coca-Cola.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.