“Judging by the increase in yields, financial markets fear the Fed might be too relaxed about the risks of an overheating economy and runaway inflation,” according to Silvia Dall’Angelo, senior economist in Federated Hermes’s international business. “Volatility in bond markets is likely to continue, fuelled by the vagueness of the Fed’s reaction function.”
In order for investors to protect their money and hedge against inflation, they should at least have a basic understanding of what is inflation, what causes it and how can they ensure that their purchasing power is not materially declined over time.
A short-term period of slightly higher inflation wouldn’t be memorable, but an extended run of inflation above 3% can be problematic. It raises your cost of living and chips away at your investment returns. Inflation can also increase the cost of new borrowing. First, lenders may want to charge more to offset the value they lose to inflation by the time their debtors repay. And then, the Fed may deploy its go-to move to combat inflation, which is to raise interest rates.
What is inflation?
Inflation is the decline of purchasing power of a given currency over time. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time.
The rise in the general level of prices, often expressed in a percentage means that a unit of currency effectively buys less than it did in prior periods. The opposite of inflation is deflation and it occurs when the purchasing power of money increases and prices decline.
Inflation aims to measure the overall impact of price changes for a diversified set of products and services, and allows for a single value representation of the increase in the price level of goods and services in an economy over a period of time.
Hedging against inflation
1. Gold & Precious Metals
Gold has been used as an inflation hedging assets by investors for many years, therefore it holds a special place in the world of inflation protection. It has been also characterized as a safe heaven in periods of economic uncertainty. When inflation looms, investors flock to gold, sending prices skyrocketing. Precious metals also make for a relatively recession-proof investment, as market turmoil leaves paper assets in freefall while gold retains its value.
Gold tends to do poorly in bull markets, but investors consider it a safe fallback in times of strife. However, gold is not a true perfect hedge against inflation. When inflation rises, central banks tend to increase interest rates as part of monetary policy. Holding onto an asset like gold that pays no yields is not as valuable as holding onto an asset that does, particularly when rates are higher, meaning yields are higher.
What we consider to be a better hedge against inflation is stock market investing. The stock market tends to outpace inflation, therefore, equity investing in an effective inflation hedge as we can see from history. That dynamic holds over long periods of time, though it can fall apart in the short term if inflation spikes. Rapid inflation is tough on businesses they absorb higher prices, too, and have to use more cash to maintain the same level of productivity.
Rising prices can often mean more profit for companies, which in turn boosts share prices. No guarantees, of course, but over the long term, the stock market has historically provided returns that beat inflation. Technology and other growth stocks, which outperform the overall market, make the most solid hedges against inflation. Consumer goods companies and others in the defensive sector, which produce basics people need, also do well when inflation surges.
3. Real estate
Real estate can be a great inflation hedge. Over time depending on the part of the country that you live in, you may have noticed that home prices have increased dramatically since the 70’s, 80’s, 90’s and so on.
Land and property values tend to rise alongside inflation, making real estate a solid hedge against inflationary concerns. Real estate is both a real asset and an appreciation-oriented one. Plus, if you own rental real estate you may get rising rents in an inflationary environment. That ability to increase your future cash flow gives you an inflation hedge if your cost of living commensurately increases.
As we have already discussed in our previous article if you’re not ready to buy actual property, you can still invest in real estate through a real estate investment trust (REIT). These are publicly traded portfolios of properties; although technically securities, they are influenced by real estate trends.
4. Crypto alternative
Advocates of Bitcoin tout its potential as an inflation hedge due to its inbuilt scarcity supply is capped at 21 million coins. Yet sceptics argue something also needs inbuilt value and desirability, not just a limited supply, to be a genuine inflation hedge.
Cryptocurrencies, like bitcoin and Ethereum, may also protect against inflation because there is a cap on their supply. But since cryptocurrencies are so new, dating back to 2010, it’s not clear how they’ll perform during times of high inflation they haven’t been around in that sort of environment. Although their prices can be hard to predict, the value of these items is expected to appreciate over time, providing returns greater than the inflation rate.
According to Alex Shields, an advisor at London-based independent financial planning firm The Private Office, It’s building a diverse portfolio that’s the key. She also added that she certainly wouldn’t be investing in a single area just to get the inflation protection.
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