How to Hedge Against Inflation: Investor’s Guide

In life, three things are certain: death, taxes, and inflation. 

Inflation measures the increase in the price of a ‘market basket’ of goods and services over a specific period of time. Due to inflation, a currency unit will be able to buy less value now than it could before. 💷

For instance, when you go out on vacation with the family expecting to spend a budgeted amount of money only to end up spending a lot more, you’ve experienced inflation. When you stop by a fuel station to fill your tank, only to get one gallon less for the same amount you paid before, you’ve experienced inflation. 

For the last few months, the U.S. consumer price index has been on a notable upward trend. In fact, as of April 2022, the meter hit a high of 8.3% from a year ago. The numbers seen during this period are the highest seen in nearly four decades. Shelter and food prices are increasing spontaneously.

In reality, though, inflation doesn’t affect only food and shelter. It affects all areas of the economy — and over time, it can take a bite out of your investment returns. 

So as an investor, what can you do to protect your investments? This guide tells you what exactly inflation is, how it will affect your investments, and what you can do about it. 

What is Inflation? 📚

Inflation is a steady increase in the price level of goods and services in a given economy. It corresponds to the erosion of the purchasing power of a currency used within a national or global economy.

In other words, inflation measures how much more expensive a ‘market basket’ of selected goods and services has become over a certain period — usually a year. A rise in the overall level of prices, commonly expressed as a percentage, indicates that a unit of currency now buys less than it did previously — the higher the percentage, the more rapid the erosion of money’s stored value.

Inflation is typically felt more intensely when prices of basic needs rise more quickly than the corresponding increase in basic income. It forces an individual to spend more to buy the same amount of goods and services, which can strain one’s financial muscle.

What Causes Inflation? 🤔

In the short-term, inflation is mainly influenced by the availability of surplus cash in the hands of consumers, also known as a hot economy. On the one hand, this can be due to people having easy access to credit and wanting to spend it. If consumers demand certain goods and services eagerly, the sellers may decide to increase their prices to cover the insufficient supply. 

In the long run, inflation can be influenced by many factors, mainly the demand-pull and cost-push effects. However, inflation can also rise and fall for reasons unrelated to economic conditions. 

For instance, the inflation surge in 2021 was caused by more complex reasons than the simple theories of demand-pull and cost-push. First, the groundwork was laid by the pandemic and the general government’s response to the pandemic. 

When COVID-19 arrived in 2020 and forced the countries to lockdown almost completely, consumer spending took a dive. Governments, on the other hand, were forced to spend tons to fill the economic void. This contributed significantly to the imbalances we see in the global economy today, leading to inflation. 

After the economy opened up again, consumers immediately started spending in excess. As such, it created a bottleneck with very high demand in an already strained economy, and the systems weren’t ready or well-equipped to handle it — causing inflation to rise further. 

The current labor shortage in the market has also contributed to the surging inflation numbers. Reduced labor causes disruption in the supply chain, which in turn pushes the prices of goods and services higher. 

In reality, many factors can trigger an increase in inflation. Here are some of the major causes:

Demand-Pull Inflation 📉

Demand-pull inflation happens when the demand is stronger than the economy’s ability to sufficiently supply. When an economy can not sufficiently meet the demand, the pressure generated pushes prices upwards — causing inflation.

A perfect example of demand-pull inflation is when the demand for tickets to see Hamilton live on Broadway was so high the tickets resold for more than £2,000 just hours after being released. These prices were well above the original price of $139 and the VIP ticket price of $549 on official channels. 

The increased demand for these tickets created an ‘inflation’ in the ‘show’s economy.’

Cost-Push Inflation 💰

Cost-push inflation (commonly referred to as wage-push inflation) happens when the prices increase due to increased production costs, such as an increase in the cost of resources (e.g. building materials) and wages.

In order for cost-push inflation to occur, demand for a particular product must stay constant while production cost changes take place. To make up for the change in production costs, the producers push up the prices of their products or services in order to manage profit levels in tandem with anticipated demand.

For example, the increasing cost of fuel in the U.S. is likely to keep pushing food prices higher and higher for the next few months.  Since fuel is used as a raw material in many sectors, the prices of various goods and services are likely to continue increasing in response to increases in fuel prices.

Other causes of this kind of inflation include wars and natural disasters such as floods, fires, pandemics, earthquakes, etc. If war or a natural disaster causes disruption to the supply chain,— for example, unexpected damage to a supply warehouse or production facility — higher production costs are likely to follow.

The Housing Market 🏠

Over the years, the housing industry has seen its fair share of price fluctuations. If there is a high property demand due to an expansion in the economy, the prices will increase. And the opposite happens when the demand for housing falls. 

When property prices increase, it doesn’t stop there; the increase also affects the price of ancillary products and services that support the housing industry — things like plumbing materials are also likely to see a surge in prices. 

In addition, there is a very close relationship between the housing market and general consumer spending. When property value goes up, property owners become better off. Some even start borrowing more against the value of their property to meet their demand for more goods and services. This increases demand in the economy, thus pushing up inflation. 

In the same way, when property values go down, people are more likely to limit their spending and hold off from making any personal investments. This pushes down inflation and, consequently, reduces inflation. 

A Rise in Money Supply 📈

The Federal Reserve is in charge of analyzing current market conditions and determining whether to adjust the prevailing money supply. Typically, it changes the money supply through Open Market Operations (OMO).   

Money supply refers to the total amount of money in circulation. In situations where the money supply rises faster than the production rate, it could attract demand-pull inflation. This causes businesses and consumers to pay more for goods, thus exerting downward pressure on the economy, resulting in a recession or depression.

Consider this: There’s $1000 and 10 guitars in an economy. If everyone who wanted a guitar were to spend money to buy one guitar, the average price of each guitar would be $100. Now imagine if the money supply in the economy went up by 30% to $1300, but the producers were only able to produce one more guitar. Since the available amount of money is more than the number of guitars available, the average price per guitar will now increase to roughly $118.

A real-life example of an increased money supply is when the Federal Reserve enacted policies to help combat the financial implications of the pandemic. This led to the Fed minting more dollars from scratch to raise the supply of money in the economy.

Policies and Regulations 🛡

Certain government policies and regulations can cause inflation — a cost-push or demand-pull inflation. For example, when the government issues tax subsidies for specific products, the demand for these products increases, which can then push the prices upwards. This happens if the demand is higher than the supply. 

On the other hand, stringent regulations could inadvertently increase costs, thus increasing inflation. For example, if the government bans the importation of showerheads, the prices of showerheads might increase if local producers cannot meet demand.  

Governments also use policies and regulations to keep inflation in check. For example, if inflation rises faster than anticipated, a government, through its central bank, can tighten monetary policy by raising interest rates and implementing other hawkish policies. Higher interest rates make borrowing more expensive, reducing consumption and investment, and relying on credit. 

Likewise, if inflation and economic activity fall, the central bank will lower interest rates and make borrowing cheaper, among other expansionary policies.

How Does Inflation Affect the Stock Market?

Although there is no need to panic in the face of the surging inflation, it’s vital to acknowledge its impact, especially on investments. A sudden increase in inflation can lead to market volatility. That is common knowledge, right?

Typically, stock prices and the general return on investments are mainly pegged on the future returns of the specific companies. 

When inflation erodes the value of a unit currency of earning, it becomes difficult for the market to estimate the current value of the stocks that make up market indexes. Additionally, increasing raw materials and labor prices impact the value as companies try to adjust.

As a result, the market prices fluctuate, causing market volatility. 

The exact effects of inflation on the stock market are not apparent. Most of the studies carried out over the years show conflicting results. However, most researchers agree that an increase in inflation has generally correlated with a decrease in equity valuations. This is because higher inflation leads to higher interest rates, reduced economic growth, and lower dividends. 

With that said, it is crucial to note that the relationship between inflation and stock prices is complex. Each stock is affected differently, and as such, there is no universal formula that can be applied — there is no single catch-all rule.

An investor with a prudent investment strategy should know to thoroughly analyze the specific characteristics of each stock under review as a unit. For some, the help of the leading stock analysis software makes this process easier.

However, there are certain things an investor can consider when carrying out such an analysis. 

• ☑ Inflation and stocks in the long run. In the long run, the monetary value of a stock in a portfolio can appreciate so that the ‘real’ wealth it holds remains stable despite the increase in prices. For example, in the case of cost-push inflation, over the period, the company will have enough time to adjust and adapt to the inflationary pressures and raise their prices. Consequently, revenues will increase, and normal profits may resume. 
• ☑ Inflation and stocks in the short run. Unlike the long-term stock dynamics, the short-term dynamics are not so favorable. In the short term, when inflation rises, the stock prices are bound to fall, and inversely, when inflation falls, the stock prices may rise.

What’s an Inflation Hedge? 📘

An inflation hedge is when an investor actively takes steps to shield the value of his investments against the effects of inflation. 

This means that even with inflation eroding the value of a dollar, the purchasing power of their money will remain the same, decreasing the risk of losing out on their investments during an inflationary period.

How Does Hedging Against Inflation Work? 👷‍♂️

Inflation can be a pain in the neck for any investor. Every investor’s motivation is to increase the value of their investment. So when this goal is challenged by inflation, it can be infuriating.

At face value, some investments might seem to provide reasonable returns. But once inflation is factored in, they are actually making a loss. To understand how hedging against inflation works, consider this: If an investor has invested in an asset whose value increases by 4%. Still, inflation is 6%, and the actual return of the said asset will actually be -2%. 

Thankfully, money isn’t the only store of value available. Changing one’s wealth medium from money to other inflation-resistant assets is a smart way to hedge against potential losses during inflationary periods. 

To hedge against potential loss during an inflationary period, a sophisticated investor will ensure that he maximizes investments that are less likely to be affected by inflation. Investments that these investors consider inflation hedges are usually highly sought after, and this keeps their prices high even though their intrinsic value might remain much lower. 

For example, even if inflation knocks down the dollar’s value, the price of gold is likely to go higher. So an investor will be compensated for the loss of purchasing power with more dollars for each ounce of gold sold. 

Assets Used to Hedge Against Inflation 📜

Although inflation is a natural occurrence in an economy, it can be frustrating for an investor looking to get high returns. 

Thankfully, there are many ways to hedge inflation. A wise investor can meticulously plan for inflation by searching and investing in multiple asset classes that are known to outperform the market volatility during inflationary climates.

Here are a few assets to consider as options for hedging against inflation:

Gold 🥇

Gold is often thought of first when considering assets to use as a hedge against inflation. In fact, one is likely to find gold in many seasoned investors’ portfolios. 

One of the main advantages of gold is that it’s a real physical asset and can hold its value for the most part. Due to this, many people tend to consider gold as ‘an alternative currency.’ For instance, gold can replace the declining currency in countries where the native currency’s value is declining.

However, it is not always sunshine and rainbows as gold can not be considered a perfect hedge against inflation. For instance, if the local government increases interest rates as a response to rising inflation, holding a non-yielding asset like gold is not as advantageous as holding a yielding asset.

Bonds 📃

Bonds are debt securities issued by a government to support its spending and obligations. Typically, bonds offer fixed returns for the asset’s lifespan, leaving their broadside vulnerable to inflationary increases. A floating bond was created to mitigate this effect. 

Floating bonds have revolving rates — the interest rates change regularly (such as annually). Usually, through its central banks, the government regularly adjusts benchmark interest rates in tandem with changes in inflation. 

This allows the returns on investments to increase as inflation increases. In other words, dividends grow in reaction to inflation-driven increases in interest rates. This is a great way to hedge against inflation. 

For example, Series I savings bonds, better known as I bonds, offer a way for an investor to lock his money’s purchasing power through the regular interest adjustments based on prevailing inflation – interest rates change every six months to adjust for inflation. 

All said and done, purchasing bonds provides a great way to preserve buying power against inflation. However, it’s important to keep in mind that bonds are a long term investment — it might take up to 30 years before it matures. 

In addition, there might be penalties or restrictions associated with redeeming bonds before they mature.  

TIPS 🌟

TIPS, also known as Treasury Inflation-Protected Securities, are types of Treasury bonds that are designed to protect investments from the effects of inflation. 

Like normal bonds, TIPS are ‘purchased debt’ issued by the U.S. government on which an investor receives regular interest payments on the face value — or the par value. 

However, TIPS have built-in inflation protection. The Treasury sells TIPS and subsequently adjusts the per value annually for inflation. 

This means that the principal amount of TIPS changes in tandem with changes in the inflation rate; hence the rate of return includes the adjustment of the principal amount. This increases investors’ interest and ensures that they’ll benefit from inflation adjustments.

But even though TIPS may appear like the perfect investment to preserve purchasing power against inflation, it is also essential to keep in mind that there is no guarantee for growth. For example, the iShares TIPS Bond ETF, which tracks a TIPS index, posted average annual returns of a little over 3% over the last decade.

Real Estate 🏢

Consider this: If Tom strives to save and can finally buy a home, he will no longer have to worry about increasing rent prices.  In the same sense, investing in real estate can be a good way to fight the effects of inflation on an investment. 

When inflation rises, property values and rental income also tend to rise. As such, it is not surprising that many inflation-averse investors rely heavily on real estate to hedge against inflation. 

However, purchasing real estate requires hefty buy-ins, which not many investors can afford. Hence the availability of many popular REITs (real estate investment trusts) that serve as a shortcut for retail investors to get their foot into the game. 

For your information, REITs have a record of performing above par: as of the end of April 2022, the MSCI US REIT Index had gone up by 40%, and its average annual return over the last ten years is 10%. 

That is a real sucker punch to inflation. 

Stocks 💸

As an investor, investing in a well-diversified stock portfolio can be an excellent way to fend off inflation. Stocks do a decent job of keeping up with inflation, as there are many factors to consider when determining how inflation affects stocks.

Usually, after inflation rises, businesses tend to gradually charge higher for their goods and/or services in order to maintain their profit share. In turn, this increases their revenue and raises their stock value – consequently increasing the investor’s average return on investment. 

For example, the S&P 500, a significant U.S. market benchmark, generated an average return of approximately 10% per year from 2001 to 2021 – with dividends reinvested. After adjusting for inflation, the average annual returns for the stocks still stand at roughly 7%.

However, stocks typically experience more market volatility than other assets. So any investor looking to invest in stocks as a means to hedge against inflation should be willing to accept volatility risks associated with the stock market. 

Other Assets 🗃

Other assets that an investor can use to hedge against inflation include commodities in the equity market,  traditional Treasuries (IEF), leveraged loans, cryptocurrencies, as well as ETFs and mutual funds.

The truth is, there is no single asset that offers a perfect hedge against inflation. Some of the assets work better than others in hedging inflation. 

In fact, depending on the state of the economy, sometimes the assets with the lowest potential can work better than an asset that has always been a well-known pillar of a perfect inflation-hedged portfolio. 

Therefore, any sophisticated investor would know to analyze all the available options and pick assets that work best for their own portfolio. Most importantly, it’s important to diversify. 

An Actual Example of Hedging Against Inflation 📝

Gold has always been top on the list for many investors actively looking to hedge inflation for their portfolios. And for a good reason. 

Typically, the purchasing power of fiat currency is always decreasing. So you will always need more and more currency units of a currency to purchase one unit of goods or services. 

For example, in 1913, one U.S. dollar could purchase 30 Hershey’s chocolate bars. But over time, the average price of goods and services has significantly increased and now, the same dollar that could buy a whole box of chocolate is now not worth more than a small McDonald’s coffee.

In comparison, the value of gold is increasing. For instance, in 1944, the value of gold was set at $35 per ounce. This was even before the surge in gold demand in 1968 that made the U.S. Congressional revoke the law requiring that Federal Reserve Notes be backed by gold.  

Over the years, the value of gold has continued to increase steadily (although with dramatic fluctuations from time to time). Gold is currently valued at $1,816.83 oz., somewhat lower than its peak in August 2020 at $2060 oz.

This is what makes gold a viable hedge against inflation. Because even as the value of a dollar declines, you will always need more units of a dollar to buy 1 unit of gold. So technically, it is not the price of gold that is increasing but the purchasing power of the dollar that is decreasing. 

It is important to remember that there are many ways an investor can hedge against inflation — hedging is not limited only to the methods mentioned above. 

A good example was in 2012 when Delta Air Lines bought a Pennsylvania oil refinery from ConocoPhillips COP.N for $150 million in an effort to cut down on $300 million annually from jet fuel costs.  This move was also a way to mitigate the risk of potential future increases in jet fuel prices.

At the time, Delta Air Lines felt they could produce jet fuel themselves at an estimated lower cost than if they were to buy it from the market, and in this way, they could directly hedge against possible jet fuel price inflation.

Is Bitcoin a Good Hedge Against Inflation? 🪙

Since inflation started to really tick up in the spring of 2021, many thought that this would be a chance for Bitcoin holders to enjoy some limelight. 

For example, billionaire investor Paul Tudor Jones was quoted saying that he views Crypto as a better hedge than gold. He went ahead to mention Bitcoin as “a great way to protect wealth over the long run,”  

But while some people like Paul are all enthusiastic, there are many countering opinions. For example, Bank of America found that although it can be used to hedge inflation, Bitcoin is not as compelling as other assets such as commodities and equities. 

So is Bitcoin a good store of wealth or not? Well, there is no definite answer to this question. 

For instance, since inflation began to accelerate significantly in the spring of 2021, bitcoin has lost 18% of its value compared to the dollar, lagging behind other risk assets such as the S&P 500 stock index, which went up by 8%, and traditional inflation hedges such as gold which went up by 7%. In fact, As of January 2022, a sell-off of the emergent asset class had reduced its worldwide market value from $3 trillion to $1.5 trillion.

Hence, the Bitcoin inflation hedge narrative is being put to the test, and it might not be faring well at the moment. But that is not to say that it can’t be in the future.  

The Pros and Cons of Hedging Against Inflation ⚖

The main reason why investors hedge against inflation is to protect their investments from possible loss of value during periods of inflation. Certain types of investments have healthy returns of investments during normal economic cycles, but their value declines significantly after you factor in the effects of inflation.  

For instance, assume that an investor acquires a stock of shares with an annual return of 5% today while planning to sell it off at the end of 1 year. If by the end of the year, inflation rates are at 6%, it means the investor will suffer a loss of 1%.

To avoid such losses in the value of their investments, investors invest in stable investments that maintain the value or grow in value during such inflationary periods.

There is also the issue of operating costs.

During inflationary periods, operating costs increase, and companies spend more to produce the same amount of goods, reducing portfolio returns. 

For instance, if jet oil prices fluctuate during inflation, this can lead to an increase in the cost of operating an airline. Consequently, this affects the profit margin of the airline and thus the value of returns on their share capital.  To keep the costs in control, companies make investments that can help them keep these costs low, like in the case of Delta Air Lines. 

When considering the downsides of hedging against inflation, however, there is one issue that stands out: market volatility.

Hedging against inflation has its limits and, if not careful, can be volatile. For example, Delta Air Lines, the company that purchased an oil company in an effort to hedge a possible rise in jet oil prices, has barely made any money from the refineries years after the transaction. 

Hence, an investor should carefully assess the market situation and other factors that affect each asset before choosing an inflation hedging asset. There is never a guarantee that any asset will be a sure shield against inflation. 

How Have Markets Reacted to Inflation in the Past? 📆

Since the start of the pandemic, inflation has been on an upward trend — hitting the highest levels seen since the early 1980s. Back then, Federal Reserve’s Paul Volker successfully controlled the price surges hitting the economy hard, which saw stocks and bonds subsequently continue to recover. 

Stock prices also did very well after World War II despite some constant spikes in inflation. This, however, continued until the mid-1960s. Then, stock and Treasury yields suffered until inflation in the 1970s was crushed. 

There were periods of inflation following the war, but the actual economy grew sufficiently to keep pace with price increases.

In the 1950s, the positive stock performance was due to increased money flow into the market. Institutions such as pension funds joined the markets and bought equities for the first time. This lowered the equity-risk premium, or the extra return investors want over government bonds for the danger of losing money.

In 1971, then-president Richard Nixon suspended the dollar’s convertibility into gold which caused the dollar to become more volatile. This quickly fed into the already high import prices making the markets more volatile and inflation uncertain. This made the equity risk premium rise again, and consequently, the stock market returns suffered. 

Today, the markets have a low equity risk premium, leaving the stocks without sufficient cushion against uncertainty. And although the government is trying to stimulate the economy and reduce unemployment actively, the gap is yet to be closed. 

This is why the Fed is letting the economy run hot — in an effort to hit full employment. 

Conclusion 🏁

Yes, inflation is unavoidable and poses a risk to every investor, regardless of whether you just joined the markets or whether you are a seasoned investor.

Money tends to lose value over time, and various economic factors control inflation rates. Thankfully, there are several investments and inflation-hedged asset classes that investors can use to hedge against the effect of inflation on their portfolios. 

As a new investor, it is important to keep an eye out for such assets, as acquiring them could help keep you safe when inflation hits to help your portfolio thrive despite the brutal economic climate.

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