Inflation is here to stay – at least for a while. Rising energy prices and supply chain bottlenecks are set to exert a surge in the Consumer price indexes much higher than previously expected by Central Banks in the advanced economies, including Canada, the Eurozone, U.S. and U.K.
With inflation at a multi-decade highs, investors are wondering how it can affect their portfolios. “Inflation affects different security types in different ways”, said Russel Kinnel, director of Manager Research for Morningstar in the U.S. “The big picture is that inflation is a greater threat to a bond-heavy portfolio than a stock-heavy one. If you are 80% equities, then you probably don't need to worry about inflation. If you are 80% fixed income, then, yes, inflation is an issue.” It hurts bondholders because it erodes purchasing power and it reduces bond values (if the expected interest rate hikes are being priced in by the market).
It’s not all bad news. Investors have some ways to hedge inflation risks. Direct hedges include inflation-linked/inflation-protected bonds, and commodities. Examples of indirect hedges are equities, gold, and bank loan funds (in countries where they are permitted by law).
Inflation-linked/Inflation-protected Bonds
Inflation-linked bonds (or Inflation-protected bonds) and funds investing in such bonds are designed to protect against inflation by adjusting the value of the underlying bond up when inflation rises and down when inflation declines. Investors must keep in mind that with inflation-linked bonds, the value of the principal rises (or falls) with changes in inflation expectations. These expectations are notoriously difficult to forecast, and so this is a key benefit of this type of securities. Keep also in mind that inflation-linked bonds can behave differently though the cycle, offering diversification in risk drivers in certain scenarios. One important consideration is duration risk, where inflation-linked bonds are often longer-dated securities, which increases interest rate sensitivity. This can at times undermine the benefits from the inflation protection.
Commodities
Another way to hedge inflation risk is through a commodities fund. Typically, commodities funds invest in derivatives linked to a commodities basket. Commodities prices are an important part of inflation and are generally sensitive to economic growth and inflation. When oil prices spike, inflation often follows in its wake, and it is what has been happening in the recent months. “Commodity prices tend to swing much more dramatically than inflation, but that makes them more of a hedge against inflation”, said Kinnel. “Commodities, unlike bonds and stocks, don't have a natural return built in. The next move is as likely to be up as down. So, if you buy a fund like this, keep it to a small position. I wouldn't let it get to even 5%.”
Gold
Gold has always had a reputation as a reliable asset to protect against inflation, but now that status has being questioned. Like most commodities, gold prices have been positively correlated with inflation over different time period. But they don’t move in lockstep with inflation. Gold can and has lost purchasing power over decade-long spans, as it did between August 1993 and December 2005. Investors who bought gold at its record high real price in January 1980 are still waiting to be made whole on an inflation-adjusted basis. In the recent inflation spike, gold is among the “failed hedges”, according to John Rekenthaler, Vice President of Research for Morningstar. He said: “The traditional inflation hedge, of course, is gold, a commodity with more than 5,000 years of price history. Since the Bureau of Labor Statistics released its announcement on inflation rise (on May 12, 2021), gold bullion has dogpaddled. Nobody looking at a gold price chart would be able to tell when inflation resurfaced”. Gold is clearly not a perfect inflation hedge, though it can help boost returns in inflationary periods.
Equities
Stocks and stock funds are indirect hedges. It may seem surprising these days because the markets are volatile and are reacting with sell-off to the news of inflation increases. But over the long haul, stocks tend to do all right when inflation rises. The first reason is simply that inflation applies to all assets, including stocks. Many companies have pricing power that allows them to raise prices. For example, companies with strong brands or that operate oligopolies can pass prices on to consumers. Moreover, if workers are getting raises in their wages, they can afford a little more in dollar terms to invest in stocks.
Bank Loans Funds
Bank loan funds are mutual funds that buy loans made by banks or other financial institutions to companies. These bank loans are usually senior secured debt and are mostly rated below investment grade because the borrower's ability to repay may be viewed as speculative. In some countries, they are not permitted by law. For example, UCITS funds under EU regulation may not grant loans, but there are different interpretations whether direct loans meet the conditions for eligibility of them within UCITS portfolios. Bank loan funds are not tightly linked to inflation, but they adjust up and down with changes in interest rates, so that makes bank-loan funds largely impervious to rising interest rates. Bank loans have several risks. They tend to be mostly below-investment-grade or unrated loans, so you have credit risk. Moreover, they can carry some liquidity risk.
What about Cryptocurrencies?
“Cryptocurrencies are often promoted as a cure to everything wrong with the dollar and modern finance”, said Kinnel. “There are limits on supply as you can't simply print more. Yet the link with inflation so far has not been very tight. I have no idea if crypto will work as a long-term inflation hedge or store of value”. For Rekenthaler, cryptocurrencies are among “failed hedges” since inflation picked up. “Cryptocurrencies are commonly regarded as electronic inflation hedges. That makes sense. Historically, gold has appreciated when fiat currencies have stumbled. So, why would the modern equivalents of gold behave differently? But behave differently they have. Unlike gold, cryptocurrencies haven’t broken even since the Bureau’s announcement. They have lost money, badly”.
