And The Award For “Best Inflation Hedge” Goes To…

Stéphane Renevier

7 months ago7:17 mins

And The Award For “Best Inflation Hedge” Goes To…

One thing’s for sure: inflation is a huge threat to your portfolio right now. But with everyone spouting lots of different theories about how to hedge against that risk, what’s less sure is the best way to protect your hard-earned gains. So let’s take a look at the six most recommended hedges, and lay out exactly which of them you should be adding to your arsenal.

Real estate

If you take out a loan to buy a property, you get decent protection against high inflation: on the one hand, the property should preserve a significant part of its value, and, on the other, the value of your loan will be reduced relative to rising prices.

But not all real estate is created equal. Of the different options, then, affordable multi-family property could be your best bet against inflation: it tends to have shorter-term leases, and hence could be more rapidly adjusted to rising prices.

Unfortunately, buying property ain’t a walk in the park: it’s time-consuming, costly, complicated, and requires a lot of capital. Of course, you could invest indirectly through real estate investment trusts (REITs), which trade on the major stock exchanges. But what you gain in liquidity you lose in protection against “bad inflation”, which arises from supply shocks rather than increased demand. That means you’d see the unenviable combination of high inflation and lower growth at the same time. In this environment, all risky assets would suffer – including REITs.

Treasury inflation-protected securities (TIPS)

TIPS are the perfect inflation hedge on paper: bonds issued by the US government whose principal value rises with inflation, while the interest payment varies with the adjusted principal value of the bond. Assuming interest rates remain unchanged, higher inflation will translate into higher cash flows and offset the loss of purchasing power.

Yet TIPS are far from perfect. First, their performance is tied to the consumer price index, which is a lagging and rather arbitrary measure of inflation that can easily be manipulated. Second, TIPS match inflation, but nothing else. That means you won’t get a lot of bang for your buck, and you’ll need an unreasonably large allocation in them if you want to really protect your portfolio. And third, this inflation protection doesn’t come for free: the yield you’ll receive is much lower than for nominal bonds. In fact, you’d actually have to accept a loss, as buying a 5-year TIPS today shows a negative yield of -1.9%.

Commodities

Commodities may well be the best hedge against “good” inflation – the kind created by a demand so strong that supply can’t catch up, which tends to drive up the price of much-needed materials. And when it does, prices rise fast: the S&P GSCI Commodity Index, for example, is up 60% over the past year. And unlike with TIPS, your beta to inflation – essentially your bang for your buck – is much higher: investment manager Vanguard has shown you can expect to make 7%-9% for every 1% in year-on-year inflation.

But commodities aren’t perfect either: some commodities might rise while others might lose, and they may simply not work in a bad inflation environment. They may not be the best long-term store of value either, since there’s no guarantee their prices will go up over a long period of time, and their performance is reduced by the costs of implementation.

Stocks

The big advantage of stocks is that they’re a good (very) long-term store of value. Hold stocks for more than 30 years, and you’re almost guaranteed to generate returns above the rate of inflation. And they work pretty well in environments of “mild” inflation too, as companies pass on rising prices to their customers.

Stocks, however, are unlikely to work well if we see either hyperinflation or “stagflation” – the combination of higher inflation and slower growth. Not only would companies’ margins get squeezed in these cases, but their valuations would also take a significant hit. Stocks are also highly dependent on investor sentiment and susceptible to manias and crashes. So given how optimistic investors are and how stretched valuations are, there’s plenty of room for disappointment.

Gold

Gold’s been investors’ favourite inflation hedge for a long time, and with good reason: it’s one of the only assets that works well in a bad inflation environment, when inflation is running high and the economy is slowing down. What’s more, investors are likely to turn to the most “trustworthy” hedge if inflation were to spiral out of control, and no other hedge has the history and pedigree of gold.

Cue the caveats. First, gold doesn’t provide any income, which goes very quickly from being a benefit when yields are low to a costly disadvantage when they start to rise. And like stocks, gold is prone to manias and crashes, meaning its short-term performance could be heavily driven by investor sentiment. And last, its long-term pedigree is now being tested by a relatively new arrival on the scene…

Bitcoin

It’s true that bitcoin hasn’t been designed to hedge against mild inflation. But when price rises are running hot and traditional currencies quickly start to lose their value, it’s hard to argue that bitcoin won’t provide protection: its supply is limited and predictable, it operates outside the control of governments, and it can be used both as a store of value and a means of payment. It should even work in a hyperinflation environment, which – if Twitter’s Jack Dorsey is to be believed – is bearing down on us. But what really makes bitcoin investors’ new favourite hedge is that its price could keep going up as it benefits from massive technological trends and a broadening of demand.

What’s the issue with bitcoin? First, it’s new, so we don’t have enough history to really assess whether it’s a good inflation hedge or not. Second, it’s volatile: even if it does hedge inflation over the long term, it might instantly lose half its value along the way. Last, it may not be a good hedge against bad inflation, since it could, like stocks, collapse when the economy slows or investor sentiment sours.

So which is the best hedge?

Trying to identify what’s the best hedge might be the wrong move. As we’ve established, different hedges have different properties and different drawbacks, which means there just isn't a one-size-fits-all best solution.

So rather than betting it all on the fastest horse, investors should first make sure they have the winning horse in their stable. To protect against good inflation, own commodities for the short term, stocks for the long term, and some real estate if you can afford to. To protect against bad inflation, make sure to add gold to your portfolio, and – if you’re feeling conservative – TIPS too. And to protect against hyperinflation, you should consider bitcoin: you may mistrust the underlying technology, but its potential for asymmetric gains means you don’t need to buy a lot of it to reap the rewards.

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