How Do Investors Hedge Against Inflation Risks

How Do Investors Hedge Against Inflation Risks

Reading time: 8 minutes

Rising prices for goods and services can prompt several reactions, from demands for higher wages to further income inequality. 

For many investors, the objective is to increase returns and limit risk, and inflation – rising prices – can influence this goal if not hedged appropriately. Therefore, it's crucial to define inflation, recognise its impact and understand the importance of implementing effective inflation-hedging strategies.   

Inflation and its Impact Explained

‘Today’s dollar buys less than it once did’.

A dollar today certainly does not buy you as much as it did 20 years ago, even 5 years ago. This is true; you would have also likely heard your grandparents and parents echo this same sentiment. 

Inflation is a measure of the general level of price rises for goods and services in an economy over a given period of time, ultimately eroding purchasing power. The CPI (Consumer Price Index) often determines inflation through month-to-month and year-on-year metrics. Disinflation, however, reflects inflation rising at a ‘slower’ rate – for example, inflation was 4.0% in June 2023, yet when compared to June 2024, it was 3.5% – and deflation refers to a sustained decline in prices for goods and services. This means prices are falling, and purchasing power is increasing (the opposite of inflation). Inflation has been a major concern in recent years for many global economies, rising strongly in 2021 and peaking in the second half of 2022. 

Central banks work with ‘inflation targets’ to help ensure price pressures remain stable (in fact, this is part of many G10 central banks’ dual mandates), with most setting their targets at 2.0%.

Just as GDP data (Gross Domestic Product) summarises the total quantity of goods and services produced within a country’s border into a single number, the CPI, the most well-known inflation measure, summarises the prices of goods and services into a single value. The CPI is based on a predetermined basket of goods that consumers ‘generally’ purchase and assigns ‘weights’ to these items according to people’s spending habits. This weighted approach is essential, as it recognises that people purchase more chicken than salmon and spend more on childcare than on books, for example, rather than treating all goods and services as equal in price averaging.

Several factors determine the way inflation occurs. Higher wages and strong employment growth can trigger increased personal consumption. Consequently, aggregate demand increases and can outstrip aggregate supply, clearing the way for companies to raise prices for their goods and services. Some of the underlying causes of inflation can be due to demand-pull inflation (excess demand outstripping supply [similar to the example above of higher wages/strong employment]), cost-push inflation (input costs rise, leading manufacturers to raise prices), monetary inflation (central banks embark on expansionary monetary and fiscal policy), inflation expectations (should companies forecast higher inflation in the future, they may increase prices of goods and services based on those views), and more. 

It is important to note that inflation affects us all differently and depends on your financial situation. As briefly stated above, however, rising prices for goods and services can significantly erode consumer purchasing power. For many, this is the single most considerable cost of inflation. This means that consumers can no longer purchase the same amount of goods and services they once did.

As we saw at the end of 2021, inflationary pressures can also trigger central banks to raise interest rates, thus increasing borrowing costs, which can see big-ticket purchases – like cars and houses – shelved for many households. Another observation in high inflation environments that we briefly described above is demand for higher wages, an action that can prompt a wage-price spiral and exacerbate the effects of inflation.

How Do Investors Hedge Against Inflation?

Investors should always be alert to the threat of inflation, particularly now with the possibility of inflationary policies from the newly elected US President, Donald Trump. 

Hedging reflects investing (or ‘diversifying’) across certain asset classes that tend to appreciate in an inflationary environment. By doing this, you help manage the effects of inflation and maintain your purchasing power.

1. Equities

While many newer investors tend to focus their inflation-hedging activities in the commodities space, the stock markets have proven to be one of the most reliable and effective hedges against inflation. For example, the S&P 500 – a market index that tracks the performance of 503 large companies listed on US stock exchanges – has, on average, returned between 8-15% annually since the early 1990s. Although US inflation peaked at 9.1% in mid-2022 and topped at nearly 15% in the 1980s, inflation has averaged around 3%, meaning that returns from the stock market would have provided a reliable hedge.

Although inflation can lead to central banks increasing interest rates, which can hinder returns in equities, a handful of stock market sectors frequently perform well. Energy and materials sectors, for example, often increase in value alongside inflation due to their connection with physical assets, which can rise when inflation does. 

Growth stocks tend to be shelved by investors, while value stocks can perform well in inflationary environments. Another option, of course, is dividend-paying stocks, which perform surprisingly well and provide a steady income stream that can help offset the effects of inflation. 

2. Commodities

For many investors, commodities have proven to be an effective safe-haven hedge against rising prices. 

While some investors turn to gold in times of inflation, its record as a go-to inflation hedge is mixed. According to Goldman Sachs: ‘The yellow metal typically only guards against very high inflation and large inflation surprises caused by losses in central bank credibility and geopolitical supply shocks. Gold usually didn’t perform well in response to positive demand shocks when the central bank responded swiftly by hiking rates’. Despite this, gold prices were largely rangebound between late 2020 and the end of 2023, while inflation was rampant in the US and across many G10 global economies. Gold only started to catch a strong bid in March this year and has recently touched record highs.

Commodities that perform well during inflationary settings are industrial base metals due to their inputs to the production process and cyclical nature and their strong connection to the housing market.  Copper – or ‘Dr Copper’ as many refer to the base metal in the investment community given its long-serving history of being able to offer clues about the future direction of the economy – serves as a significant input to many consumer goods and has a wide application in the industrial sector. When an economy is doing well, and production is high, demand for copper will increase and cause prices to rise, which, by extension, causes the production process to become more expensive. It is important to note that copper prices are often viewed as a leading indicator of economic performance, rising before consumer prices do. Energy is another commodity that investors regularly use for hedging against inflation, given its ability to respond to both supply and demand shocks. In fact, according to an analysis from Bloomberg, energy and copper have proven to offer the most superior inflation hedges.

You can invest in stocks and commodities in several ways. Contracts for Differences (CFDs) are popular low-cost options, in addition to futures and options markets, as well as Exchange-Traded Funds (ETFs).

The Importance of a Diversified Portfolio

Thinking about risk, return, and the influence of inflation is critical for any investor.

Investing in one asset class is generally not recommended as it exposes your capital to unnecessary risk. Spreading your investments across various asset classes can help achieve a balanced portfolio, increase your risk-adjusted return and help shield your portfolio from inflation. However, it should be noted that the effectiveness of a diversified portfolio depends on its specific composition and the prevailing economic conditions. It's essential to regularly review and rebalance your portfolio to ensure it aligns with your financial goals and risk tolerance.

A balanced portfolio that aligns with your risk tolerance can help shield your investments from market volatility and increase overall return. When one investment underperforms, the other asset classes may outperform and compensate for losses. Investors tend to invest in five main asset classes: Stocks, Bonds, Commodities, Cash and Cash Equivalents, as well as Real Estate (REITs). 

FAQs:

1. What is inflation?

Inflation is defined as the general rise in prices for goods and services in an economy over a period of time.

2. What causes inflation?

Several factors can trigger price rises, from demand-pull inflation to wage increase demands and monetary inflation.

3. How can Investors hedge against inflation?

Investors can hedge against inflation in a number of ways, including investing in equities and commodities, as highlighted in the article. However, investors may also turn to bonds. Inflation-linked bonds are ‘linked’ to move in line with changes in the rate of inflation (for example, in the US, this is the CPI). Unlike regular bonds, the principal value at maturity and interest payments are adjusted for inflation according to changes in the CPI.