How to hedge against inflation

Inflation and your portfolio: what you need to know

‘Money doesn’t go as far as it used to’. This, much to everyone’s exasperation, is true. When inflation sets in, each unit of money becomes less valuable because it can be exchanged for fewer goods and services. Put another way, money loses its purchasing power because prices rise.

The rate at which this occurs is the inflation rate – the higher the rate, the more rapid the erosion of money’s stored value.

To determine the inflation rate, economists look to price indices to collect price data across a wide selection of goods and services. Since 2017, the consumer price index (CPI), including owner-occupiers’ housing (CPIH), has been the leading inflation index in official UK statistics.

If the inflation rate is high, this index – and its prices – have increased significantly over a set period. You are, essentially, the poorer for it because the amount of wealth held by your money has decreased.

The good news is that money isn’t the only store of value available, and that by moving wealth into inflation-resistant assets, you can shield it during inflationary periods. Given your level of experience and expertise with financial instruments, you may want to employ more sophisticated market strategies to hedge against potential losses.

Determining how inflation affects your portfolio is, unfortunately, a complex affair. But, a few general principles can be applied:

• Non inflation-indexed bonds often fall in price during periods of high inflation, so expect your portfolio to drop in value if they make up a significant portion of your holdings
• Inflation-protected bonds, by comparison, adjust coupon payments and the principal to meet inflation
• Research shows that stocks typically co-move negatively with inflation (ie when inflation rises, share prices drop) – but, this isn’t always the case, and could be seen as a predominantly short-term phenomenon
• In the long run, a well-diversified stock portfolio could act as an effective hedge
• Your mix of growth stocks, value stocks, income stocks and defensive stocks will also affect your portfolio’s value
• Real estate prices and rental incomes adjust upwards in step with inflation
• Commodities may provide a good defence; and gold, a safe-haven asset, is traditionally looked to as a hedge
• Derivatives like CFDs can be used to short-sell markets, thereby off-setting losses caused by drops in asset prices. Short-selling, however, is a high-risk trading method that can incur potentially unlimited losses

What assets can protect against inflation?

Several assets can be looked to for protection against inflation, including:

• UK index-linked gilts and US treasury inflation-protected securities (TIPS)
• Real estate investment trusts (REITs), exchanged traded funds (ETFs) on REITs, and physical real estate holdings
• Commodities and commodity exchange traded products (ETPs)
• In the long term, stocks can correct for the effects of inflation – meaning that share prices and dividends will rise

Index-linked gilts and TIPS

Inflation is usually bad news for bond holders. This can be attributed to two factors:

• A bond’s fixed coupon payment amount become less valuable to investors when money loses its purchasing power
• Central monetary authorities like the Bank of England (BoE) often react to high inflation by raising interest rates. As interest rates and bond prices are inversely related, the higher interest rates result in a lower market price for the bond (should the bond holder want to sell)

For those looking to get into the bond market at a favourable price, this may present an opportunity. For those looking to store their wealth in assets that retain their real value over time, UK government-issued index-linked gilts and US TIPS may be a better solution.

Index-linked gilts were introduced in 1981 and use the retail price index (RPI) as their inflation measure. They provide coupon payments in six-month intervals, and repay the principal at maturity. Their coupon payments are adjusted to reflect inflation, but there is a lag: for index-linked gilts issued prior to 2005, the lag is eight months; and for those issued post 2005, the lag is three months. In practice, this means that the coupon payment will reflect the inflation rate as measured three or eight months prior.

On the plus side, over the past decade, the RPI has been consistently higher than either the CPI or the UK’s official inflation rate, the CPI including owner-occupiers' housing costs (CPIH).

US TIPS are similar to the index-linked gilts, but use the US CPI to adjust the face value of the security. This affects the interest payments as they are calculated as a per centage of the now higher principal. Whereas TIPS may be one of the best investments during inflation, the downside is that they stand to underperform during periods of deflation as their face value decreases.

REITs, REIT ETFs and real estate

As a class, real estate shows resilience as both rental prices and property values tend to rise in step with inflation. Research suggests that, by some measures, returns on housing over the very long run are comparable to equity returns, but show less volatility and are less exposed to the business cycle. This makes real estate one of the best hedges against inflation.

But, physical real estate holdings require substantial minimum capital outlays, making them inaccessible to a large section of investors. Viable alternatives include REITs and REIT exchange traded funds.

REITS are similar to mutual funds in that they make use of the power of pooled funds for investment purposes. Dissimilar to mutual funds that buy securities like stocks and bonds, however, REITs buy income-producing real estate assets.

They were established in the US in the 1960s, and since their more recent introduction to the UK, have proven to be very popular investment vehicles.

As mentioned, REITs buy income-earning properties that generate revenue for the fund. This is distributed to the fund’s shareholders as dividend payments. REIT shares are exchange listed, and can be sold and bought by investors much like ETF shares.

A share in a REIT offers immediate exposure to the real estate market at a fraction of the cost of buying property. The value of the share is shielded from inflation by the fact that its dividends are based on rental income, which should correct for inflation relatively quickly. Moreover, REITs are required to pay up to 90% of their income as dividends – a definite drawcard for investors wanting to own income-generating stocks.

A possible downside is that a REIT may be concentrated geographically, which opens the door to other risks. To mitigate the risk of geographic concentration, investors can look to further diversify into real estate by purchasing shares in several REIT-tracking ETFs. Popular REIT ETFs include the Vanguard REIT ETF, the Schwab US REIT ETF and the iShares Global REIT ETF.

Learn more about REITs

Commodities

Because commodities are used as inputs for an extensive range of industries, their prices can be seen as an indicator for expected inflation. If, for example, demand for goods and services in the wider economy is strong and companies are bidding for commodity inputs, prices will increase.

Likewise, if shocks occur and commodity supplies are constrained, their prices will also rise given a steady demand. In either of these cases, a spike in commodity prices will likely precede a higher rate of inflation.

This price appreciation means that exposure to the commodity market can be a good hedge against inflation. For many investors, owning an actual commodity like gold or oil is infeasible – so access through shares in a commodity ETF may be the most practical solution.

Commodity ETFs will either purchase the commodity itself or buy securities like shares in commodity-linked companies (eg mining houses or oil producers), or both. This depends on the particular fund. Additionally, they may use derivatives like futures or swaps to track the performance of a specific commodity, industry, sector or commodity index.

Other ETPs that offer exposure to commodities include exchange traded notes (ETNs) and exchange traded commodities (ETCs). ETNs and ETCs are debt instruments (as opposed to shares) but can be bought and sold on an exchange like ETF shares. Their principal amounts – and therefore their prices – fluctuate according to the price of the commodity they track.

Of all the commodities, gold is perhaps the most favoured by seasoned investors as a safe-haven asset. During periods of high inflation, financial uncertainty and currency devaluation, gold prices rise as demand for the precious metal increases.

For example, in mid-2020, amidst fears about the continuing economic impact of the coronavirus and further national lockdowns across the globe, the gold spot price reached $2058.40 per troy ounce – a previously unseen high.¹ Moreover, the average gold price in 2019 was $1392.60, which rose to $1769.64 by the end of 2020.² This represents a year-on-year increase of just over 27%.

Whereas the gold market can be accessed via the exchange traded products mentioned above, you could consider using derivatives like CFDs to speculate on its spot price, as well on the prices of gold futures and gold options. As CFDs are available on shares, positions on the share price of gold-linked companies are yet another way to get exposure to the broader gold market in times of high inflation.

Learn more about trading gold

Well-diversified stock portfolios

The relationship between stocks and inflation is not straightforward, and each stock should be assessed on its individual merits when it comes to developing a sound investment strategy. With this said, a few guidelines can be mentioned.

In the long run, stocks are inflation-busting.

The first of which relates to the length of your investment time frame. In the long run, a well-diversified stock portfolio can hedge against inflation as companies are given enough time to adapt their practices, prices and inputs to the new conditions. This enables them to restore normal profit margins and real (ie inflation-adjusted) revenues.

In essence, once an appropriate period has been allowed for, companies tend to pass the higher prices on to consumers who, in their turn, can afford these prices as their own wages and salaries have also increased.

As is evidenced in the graph below, inflation-adjusted returns on global stocks outpaced savings accounts, UK gilts and 50/50 portfolios significantly over a 15-year period, given the same initial investment amount.

In the short run, inflation is stock-busting.

By contrast, analysts suggest that the short-term dynamic is less favourable. That is, the relationship between share prices and inflation is (quite frequently) an inverse correlation – as inflation rises, stock prices fall, or as inflation falls, stock prices rise.

All shares, however, are not created equal.

• Value stocks: there are indications that value stocks are preferred by investors when inflation is high. Value stocks have a higher intrinsic value than their current trading price, and are frequently shares of mature, well-established companies with strong current free cash flows
• Defensive stocks: companies that provide goods or services that are relatively insensitive to economic downturns retain their value during periods of constrained consumer income. They are often used as a hedge against weak macroeconomic conditions, but could underperform in positive markets
• Growth stocks: research suggests that growth stocks decline in price during high inflation. Growth stocks don’t offer immediate returns or dividends, but they demonstrate the potential to outperform the market in the future. The promise of future returns becomes less attractive when inflation lessens the value of those potential returns
• Income stocks: as income stocks pay regular and stable dividends, which may not keep up with inflation in the short run, their price could decline until the dividends rise
• International stocks: companies competing in international markets, or against foreign companies in local markets, may experience a falling share price during periods of high inflation. If the company raises prices too much, it runs the risk of becoming uncompetitive

Learn more about trading shares

How to hedge against inflation

Hedging is often compared to taking out an insurance policy on your securities, and can be seen as a way to mitigate your losses should the market turn against you. It is achieved by strategically placing trades so that a gain or loss in one position is offset by changes to the value of the other.

Any strategy adopted when hedging is primarily defensive in nature – meaning that it’s designed to minimise loss rather than to maximise profit.

Typically, to hedge a position, you would either take an opposite position in a closely related market (or in a closely related company), or the same position in a market that moves inversely to your original investment.

Although this should lessen the adverse effects of your losses in the event that they occur, it will also lessen any profits should the market move in your favour.

To protect yourself from inflation, you could hedge against existing positions through leveraged derivatives like our CFDs.

Learn more about hedging strategies

Hedge against existing positions

When hedging against existing positions, you can use CFDs to speculate on the price movements of your chosen asset without ever taking ownership of the asset itself.

For example, if you think that the value of your growth stocks is set to decrease due to the announcement of a higher-than-expected inflation rate, you could take a short position on your shares using CFDs. If your shares were to drop in price, the gains earned on your short CFD position could reduce those losses.

CFDs are generally seen as a good instrument for hedging. Additionally, futures CFDs don’t incur overnight funding fees, which is beneficial if you’re looking for longer-term protection.

Learn more about short-selling

It’s important to bear in mind that spread bets and CFDs are leveraged derivatives. While leverage can lower the cost of opening a position, it will also amplify both profits and losses. When trading with leverage, it’s vital to manage your risk properly.

Hedging against inflation summed up

• Inflation is a lessening of money’s purchasing power. It can erode your stored wealth if you keep that wealth in cash holdings
• Wealth, however, can be stored in inflation-resistant assets that appreciate in price to retain their real value
• Inflation-resistant assets include UK index-linked gilts, US TIPS, REITs, commodities like gold, and a well-diversified stock portfolio (in the long run)
• Hedging is used as a way to minimise potential losses. It is achieved by strategically placing trades so that a gain or loss in one position is offset by changes to the value of the other
• You can use leveraged derivatives such as CFDs to take a position in a market and hedge against inflation. Alternatively, you could use a share trading account to buy and own inflation-proof assets

Footnotes:

¹ Macrotrends.net, 2021
² Statista.com, 2021