As investors continue to lament recession worries and market volatility, the US Inflation Rate cooled to 8.52% in July 2022 after reaching 9.06% last month. Perhaps the Fed’s four rate hikes this year are serving their intended purpose of easing inflation from levels not seen since the 1980s?
Inflation is a rise in an economy’s overall average price level and a decline in the purchasing power of that economy’s domestic currency. Core Inflation measures changes in the overall price level minus food and energy costs.
It’s important to note that inflation affects more than just the price of consumer goods, as measured by the Consumer Price Index. Nearly every asset class can take a hit from inflation in one way or another. While rising prices can be a sign of economic growth, translating into higher corporate earnings and elevated stock prices, it is a double-edged sword. Historically, rapid inflation prompts central banks to hike interest rates to control runaway prices. Bond yields rise causing prices fall, future corporate earnings are discounted further while equities sell off, and any adjustable rate credit product becomes more expensive.
If inflation makes you queasy—and switching to day-old milk is not your idea of coping with inflation—then you’re in the right place.
Here are seven of the best ways to hedge your portfolio against inflation:
Inflation is typically regarded as a negative for stocks, as it increases companies’ borrowing and production costs, further discounts future earnings, and ultimately leads to lower expected earnings growth. If the earnings of US companies are expected to shrink, investments that exclude domestic companies (i.e Ex-US funds) can hedge a predominantly US portfolio and capture potential returns from worldwide markets where inflation may not be as high.
• Vanguard FTSE All-World ex-US Index Admiral (VFWAX)
• State Street Global All Cap Equity ex-US Index (SSGVX)
Per the theory of diversification, the less correlated two investments are, the more they can protect investors from downside risk. A portfolio’s overall volatility can potentially be limited by expanding the variety of investments in a portfolio. While diversification is typically approached in terms of asset classes, it also applies geographically. In this case, increasing exposure outside of the US could make for an effective hedge against domestic inflation.
2. “Defensive” Stocks
Though rising inflation has historically led to Fed rate hikes which can stymie stock market returns, certain sectors act as a counter to higher inflation since they tend to appreciate in times such as these. Materials, Consumer Staples and Utilities are examples of lower-volatility sectors that defensive investors often rotate into. When both inflation and the prices of raw materials rise, Materials stocks have followed upward.
As for Consumer Staples, many of the companies in that sector are considered “recession-proof”. Think household products, personal care items, and groceries—no matter if inflation is 1% or 10%, everyone will need to do the dishes, brush their teeth, and eat, right? Therefore, consumer staple companies are favored by investors seeking protection from inflation, since they are thought to deliver consistent earnings with lower volatility no matter the current economic environment. Finally, the merits of the Utilities sector in an inflationary environment include the average stock in that sector sporting the second-highest dividend and lowest beta of the eleven sectors. Utility stocks are often viewed as a sort of bond hybrid, sporting the risk-off elements of fixed income instruments with the ability to generate current income via dividends. And, similar to Consumer Staples, many Utilities companies are considered recession-proof as people depend on powering and heating their homes.
3. Bonds, including TIPS
The Fed’s Open Market Committee (FOMC) hikes the Fed Funds rate as a means to control inflation, leading to higher interest rates across all fixed income durations. During inflationary periods, investors might consider expanding their fixed income positions, as higher risk-free returns make bonds more attractive compared to risky assets such as equities. But be aware: timing is everything. Purchasing bonds after markets have priced in a rate hike is one thing, but buying them before a rate hike occurs might lead to depreciated values of those bonds.
Treasury yields are typically one of the biggest beneficiaries during rate hikes, as seen most recently in 2016 and 2022.
Treasury Inflation Protected Securities (TIPS) are fixed-income instruments similar to treasury bonds, but they’re specifically designed to protect against inflation. Just as treasuries fluctuate based on interest rates, TIPS principal values appreciate when inflation rises. During inflationary periods, TIPS can provide added returns and protection to a portfolio if or when equity prices dive. TIPS are available in 5, 10, and 30-year durations.
4. Foreign Currencies
Inflation not only decreases a currency’s purchasing power domestically, it can also weaken a currency compared to other countries’ tenders. A weaker exchange rate can stimulate activity from foreign buyers. For example, the US dollar and Euro were recently at parity for the first time in 20 years, making that long-awaited trip overseas less expensive. On the flip side, holders of the weakened currency are at a disadvantage when purchasing from foreign nations. For instance, the US dollar experienced relative weakness against the Pound, Canadian Dollar, Euro, and Australian Dollar from March 2020 through the first half of 2021, partially due to rising inflation. But as inflation hit the rest of the world in 2022, the US Dollar strengthened once again.
The Japanese Yen has often been regarded as a safe haven for US dollar holders in times of economic uncertainty. Japan’s historically steady economic growth and inflation rate have resulted in tame exchange rate fluctuations, providing a hedge against the inflation-induced devaluation of the US dollar.
Those who wish to diversify out of fiat currencies entirely might seek alternative stores of value. One emerging asset class, cryptocurrency, includes digital assets like Bitcoin, Ethereum, and Cardano. While recent price declines have prompted some to question the reliability of cryptocurrencies as inflation hedges, their broad appeal as a decentralized store of monetary value is gaining popularity.
Are you an advisor seeking ways to explain the current “crypto winter” to clients? Watch our recent sitdown with Ric Edelman, Founder of Digital Assets Council of Financial Professionals, who gives his thoughts on the future of digital currency.
In addition to owning physical gold, investors can consider adding gold miners, ETFs, or even currency-hedged gold funds to their portfolios to “stay golden” through inflation. Some of these plays include SPDR Gold Shares (GLD), iShares Gold Trust (IAU), VanEck Vectors Gold Miners ETF (GDX), and Aberdeen Standard Gold ETF (SGOL).
Other tangible assets include commodities, such as oil, lumber, and steel, whose prices not only increase with inflation but also act as indicators of both future inflation and economic growth. As the economy expands, the demand for commodities heats up, pushing their prices higher.
Like precious metals, real estate is a tangible asset that tends to hold value during prevalent inflation. As prices rise, so do property values and rents, increasing the amount of rental income earned along with the book value of property.
Existing homeowners may actually welcome inflation as it translates to more valuable equity. As seen in the chart above, the US Existing Home Median Sales Price has soared along with inflation to new all-time highs in 2022. However, real estate taxes could increase in kind. If you’re considering buying a home for the first time, dramatic home price hikes over the past two years might have you second-guessing that corner lot in the ‘burbs.
Alternatively, the benefits of owning actual real estate can be captured by adding Real Estate Investment Trust (REIT) holdings to a portfolio. REITs typically operate conglomerates of real estate and are investor-owned. Those investors receive distributions on the REIT’s rental income, interest, and property sales. There are hundreds of REIT equities, ETFs, and Mutual Funds in the YCharts database, in addition to general real estate sector securities such as the SPDR Select Real Estate Sector ETF (XLRE).
The Bottom Line
Whether it’s at the grocery store or out on the road, consumer demand and healthy economic activity (or sometimes money printing and resource scarcity) ignite inflation and send prices higher. Though consumers and investors alike have valid reasons for concern, there are many ways to protect long-term investments against the threats of inflation. From ex-US investing to snapping up gold and property, the number of available options to hedge your portfolio against inflation should keep you sleeping well at night.