An Introduction to Inflation Hedges
In June 2022, the inflation rate climbed to 9.1%, the highest its been in over 40 years. Such drastic inflation spikes contribute to market volatility and economic instability, which can often create upheaval in the traditional stock market.
Inflation impacts every investor, regardless of portfolio size. One of the most vulnerable asset classes during times of high inflation is cash, as the most direct impact of inflation is a decrease in purchasing power. For example, if you hold $100,000 in cash during 2022 inflation levels (9.1%), you’ll lose $9,100 in purchasing power.
What Is An Inflation Hedge?
An inflation hedge is an investment meant to protect a portfolio from diminishing purchasing power due to inflation. These hedges are typically assets expected to maintain or increase in value while inflation rises. On the other hand, some hedges may still be expected to decrease in value, just at a slower pace than the value of the currency.
In response to rising inflation, central banks ideally use monetary policy to maintain normal levels of inflation. We can see this in the US with the Federal Reserve implementing the steepest interest rate rises in over 40 years.
How Do Inflation Hedges Work?
Hedging against inflation means taking steps to protect the value of an investment portfolio from the effects of inflation. Certain investments might seem to provide a decent return, but when the loss in the currency’s value is factored in, sometimes they are sold at a loss.
For example, if a trader purchases a stock that gives a 5% return, but the inflation is above 5%, the trader will still see a loss in overall value when that asset is sold.
Assets widely considered to be inflation hedges can often be self-fulfilling — investors flock to these assets when purchasing power decreases, which keeps their values high regardless of intrinsic value.
There are a few ways to attempt inflation hedging. One option is to purchase assets whose value tends to be positively correlated with inflation. If inflation rises, their values will rise in conjunction. Another option is to invest in securities specifically designed to be inflation hedges, such as bonds that pay an interest rate partially based on the rate of inflation.
The Best Inflation Hedges
Diversify With Alternative Assets
One way to mitigate inflation-related financial loss, especially when high levels of inflation are also met with high market volatility, is to diversify your portfolio with alternative assets. Hard assets such as collectibles, real estate, and precious metals have long been considered investments that provide inflation protection.
The fine art market is largely dependent on buyer sentiment, meaning when inflation rises and investors are searching for a hedge, the art market can still see appreciation. Art also has an intrinsic value beyond investment, as it gives the owner the pleasure of looking at it on their wall — this value cannot be stripped away with inflation. For investors looking to diversify without purchasing a multi-million dollar art piece, they have the option to invest in fractional shares of contemporary artwork.
Historically, art has repeatedly proven to be a strong inflation hedge — May of 2022 saw the three major auction houses in New York sell a record-breaking $2.8 billion, including setting numerous records for blue-chip artists like Andy Warhol, Jean-Michel Basquiat, and Yayoi Kusama. These impressive results happened as the stock market saw multiple stumbles.
Real estate is another popular inflation hedge. When people buy their homes, they no longer need to worry about rising rents, one of the most impacted areas of rising inflation.
Real estate investments, or buying property for more than just a place to live, can also help investors hedge their portfolios against inflation. Since 1990, real estate investment via REITs (Real Estate Investment Trusts) has historically hedged against the impact of inflation.
Returns from both real estate and infrastructure have a positive correlation to inflation, as found by Blackrock’s research. Real assets are able to capture inflation through greater income growth due to increased rents, occupancy, and increased demand for underlying goods such as electricity.
Commodities and raw materials such as oil and corn are other popular alternative assets used for inflation hedging. Historically, when inflation has risen, the price of goods, including commodities, has risen. Tangible assets such as oil, lumber, and steel have prices that increase with inflation as well as act as indicators of future inflation and economic growth. As the economy expands, the demand for commodities heats up, pushing prices higher.
Precious metals including gold are among the most commonly thought-of assets when it comes to good inflation hedges. Many global currencies used to be backed by gold for its perceived store of value. While gold has historically been viewed as the standard for inflation hedging, its low correlation to CPI since the 1970s indicates that it may not be the inflation hedge it once was.
Treasury Inflation-Protected Securities (TIPS)
One of the most obvious inflation hedges is Treasury Inflation-Protected Securities or TIPS. TIPS is a type of U.S. treasury bond designed explicitly to help investors hedge against inflation. Like other bonds, investors can purchase TIPS by lending money to the government and receiving interest in exchange.
TIPS have a fixed rate of interest and adjust the principal value of the bond based on inflation determined by the Consumer Price index (CPI). When CPI rises, the principal value of the bond rises as well, meaning investors accrue more interest and receive more money when they redeem their bonds. On the other hand, if the CPI falls, the principal amount will fall as well, along with the interest payment.
Investors can also choose to invest in TIPS ETFs (exchange-traded funds) if they do not want to purchase the individual bond.
Typically, as inflation rises, businesses have to charge more for the product or service they sell in order to not decrease in profit. Stocks are generally able to keep pace with inflation.
However, stocks also experience more price volatility than any other asset class, so investors must be willing to accept that volatility risk when investing in shares.
When the Federal Reserve hikes rates to control inflation, it becomes more difficult for businesses to borrow capital which may impact production and ultimately profits. Some sectors actually benefit from rising interest rates, such as financial services — the firms that stand to gain on interest charged for loans.
Consumer staples, such as energy and food, also have strong pricing power because they are able to easily pass through inflation to consumers without impacting demand. When the same dollar isn’t going as far as it did a few months ago, consumers are more likely to skip out on restaurants and vacations than they are to stop buying groceries or gas.
As a result, the stocks of consumer staples companies are able to remain stable even while inflation surges.
High-growth stocks, on the other hand, are less able to pass through inflation to the consumer because they often rely more on borrowing. Rising rates discourage lending, meaning fewer people are willing to lend to growing businesses.
Fixed income instruments usually offer a fixed payment for the duration of a bond, meaning most bonds have broad exposure to inflation rises. One way to mitigate this effect is with a floating-rate bond, where the payout rises and falls in response to upticks in a benchmark rate (often LIBOR or similar).
Similar to TIPS, investors can gain allocation to floating-rate bonds through ETFs or mutual funds, which typically own a wide assortment of like bonds. This method provides diversification along with inflation protection, meaning your portfolio may benefit from even less risk.
Short-term bonds are more resilient during inflationary periods than long-term bonds due simply to the bond’s shorter maturity. Long-term bonds will end up losing more value over the duration of the bond’s life.
Inflation not only diminishes a currency’s purchasing power domestically, it can also weaken a currency compared to other countries’ fiat currencies. Though a weakened currency can stimulate activity from foreign buyers, holders of that currency are at a disadvantage when purchasing internationally.
For example, 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 potential hedge against inflation-induced currency deflation.
Investing in Art as an Inflation Hedge
Rising inflation presents a large concern for investors, especially in the current inflationary times which are impacting global economies, with the US also seeing rising rates and slowing economic growth.
a well-diversified portfolio is commonly regarded as one of the best ways to hedge against rising inflation. One way to diversify your portfolio is by purchasing fractional shares of contemporary art with Masterworks.
Masterworks is the first platform making it possible to invest in multimillion-dollar works from artists like Banksy, Kaws, Basquiat, and more. Masterworks’ industry-leading research and acquisition teams use proprietary data and art market expertise to curate a collection of iconic works of blue-chip contemporary art.
Masterworks only invests in contemporary blue-chip art, democratizing access to fine art investing.
See important Regulation A disclosures at masterworks.io/cd
This material is provided for informational and educational purposes only. It is not intended to be investment advice and should not be relied on to form the basis of an investment decision.