How Can You Hedge Inflation Risk?

Inflation risk is something the old know a lot about and the young do not appreciate! The earlier you understand it, the easier it will be to counteract its effects. As surprising as it sounds, you can make money from inflation. Your capital preservation strategy will suffer if you do not understand how it works and what it can do to your purchasing power. 

Takeaways

• Understand inflation risk

• How to protect yourself from loss of purchasing power

• What instruments can be used to profit from inflation

What is inflation risk?

It is the risk that any growth in your assets is eaten away by inflation. If your assets increase by 10% but inflation increases by 15%, you will be funding that 5% difference from your existing capital, i.e. you will be getting poorer!

Inflation comes about because of the increased price of raw materials. If the price of sugar goes up, the manufacturer of sweets will correspondingly increase their prices to protect their profit margins.

Inflation risk affects us all.

If over time, this leads to sweets increasing in price by 10% and you buy a lot of them, you will be getting progressively poorer, as a larger portion of your earnings is spent absorbing the increased cost. This increased cost on your salary is because of your loss of purchasing power.

You want your weekly dose of sweets, but your salary has not gone up with inflation (price increases), and as result you either have to buy less sweets at a higher price, or the same amount of sweets for a greater outlay.

Government guarantees

One way of protecting yourself from inflation is to buy "Linkers", or better known by its formal name: Index-linked Gilts. Firstly these are UK government bonds. I.e. They are guaranteed by the U.K. Government. Brexit apart, the UK is one of the safest places to invest in.

Secondly Linkers work by their coupon and the repayment value of the Gilt being adjusted for inflation. They measure inflation against the Retail Price Index. If prices rise (such as the price of milk) then this is reflected in the coupon of this bond.

As a result, the value of the bond also rises as their yield becomes more valuable in reducing inflation risk. Linkers are therefore a form of portfolio protection.

USA USA USA

You also have the option of buying the US version, called Treasury Inflation-Protected Securities (TIPS). This can be attractive to investors who want dollar denominated exposure as well as a US focused inflation hedge in their stock portfolio.

Different countries can suffer inflation at different times. Therefore having inflation adjusted bonds from different countries, can mean protecting and profiting at different times.

In uncertain times, buying the iShares ETF which gives you exposure to TIPS is also attractive because of the 'close' relationship between the Fed and Blackrock. Blackrock is the owner of the iShares brand. Anyone buying and selling iShares ETFs in early to mid-2020 will have noticed the increased liquidity in iShares ETFs versus Vanguard ETFs.

Yellow metal protection

Gold is seen as an inflation hedge, because it is, well, gold. There are so many pros and cons on gold investing as an inflation hedge, that it is unclear whether it is! It is worth noting, that with so many investors believing it to be a hedge, then you can ride the wave of support it gets. The main argument for gold seems based on it being a hard asset. I.e. if you own the physical form, i.e. non ETF/electronically held one, you can sell it at the price you want to sell it at. As a result, it is a store of value.

That is assuming that price discovery works in your favour and someone will offer you your asking price. The issue with gold though, is that it does not yield anything and has to be stored if held in physical form. That is expensive and you risk it being stolen as it is easily transportable. As part of a common sense approach, having some gold exposure as a long-term hedge to inflation is sensible, but as an undisputed hedge? I would not bet a mortgage on it.

The equities hedge

Companies can raise prices to compensate for inflation. We all need food and cleaning products. The likes of Unilever and Reckitt Benckiser, are therefore in a position of strength to raise their prices to counteract inflation and protect their profits.

To be clear, inflation also affects companies, as their suppliers raise the cost of raw materials. These raw materials are needed to manufacture their products. A word of caution though, sometimes things do not go quite to plan.

Equities are an imperfect inflation hedge. 

Although not inflation specific, in 2016 as a result of the Brexit vote and drop in value of Sterling, Unilever pushed through a price increase until the Tesco CEO said no. As part of this disagreement, Tesco even started removing Unilever products (Marmite no less) from its shelves.

What made things more interesting was that the Tesco CEO was a former Unilever man! Unilever caving in was probably an exception and not the rule. You should  always be prepared for the exception.

Due to equities being seen as an inflation hedge, investors will invest large amounts of money into them. This forces the price of equities up faster than their earnings grow.

This can have the effect of negating inflation because the share price increase of +10% (for example) is higher than inflation (for example) +5%. Yet the 5% growth in the share price, is actually equity investor exuberance and potentially also momentum trading.

In effect investors are, themselves, creating an inflation hedge by pushing up equity prices sky high! In the process these overvalued stocks become an equity risk themselves!

Conclusion

Inflation is the unseen risk of investing and it can be costly over the long-run. Today's generation have been used to inflation in the low teens. But cast your mind back to the 1980s Britain!

Inflation was then regularly above 10%, whilst unemployment and therefore wage growth was low. It is not inconceivable that some form of inflation is possible in future - downside risk comes in many forms. Hedging inflation risk today will mitigate its destructive power tomorrow!