Hedging Portfolios in Inflationary Economic Regimes
Updated: Jun 29, 2022
Reflection Series - Inflation and your portfolio: Part Ii
For a generation of investors who have rarely had to worry about their wealth being eroded by inflation, the surge seen since the beginning of the year will mark a major change in their investment habits and should lead them to consider some strategic adjustments, particularly in some of the asset classes in which they have underinvested over the past decade.
There are many ways for investors to protect themselves against inflation, including some investments designed specifically to protect against inflation; but unfortunately, there is no perfect way to protect investment portfolios against inflation. There are pros and cons to almost any product or investment that claims to protect portfolio returns from inflationary erosion. That said, depending on the growth environment (in other words, whether economic growth is high, medium or low) and economic regime, certain asset classes tend to outperform others on a purely relative basis. As part of an investment policy, it is important to take into account the different sources of risk premia in order to achieve structural diversification that allows the portfolio to be well balanced to cope with all possible inflationary economic regimes. For all-weather protection in times of rising inflation and economic uncertainty, portfolios will be best hedged by a dynamic asset allocation policy that allows for navigation between the four inflationary economic regimes with minimal or controlled loss.
Figure 1: Four Inflationary Economic Regimes
The ideal investments to protect against inflation are those that in a given economic regime hold their value during inflation or increase in value over a period of time.
How does hedging against inflation work?
Inflation reduces the overall value of portfolios over time, Hedging portfolios against inflation simply means taking steps to offset the effects of rising prices on investment returns. An inflation hedge strategy attempts to protect against this erosion by seeking returns that are higher than the level of inflation, but It could also mean investing in an asset expected to decrease in value less quickly than an expected decrease in the value of the currency. When looking to protect your investments during high inflation, a good option is to purchase non-cyclical assets. These investments are more likely to remain stable during a high inflationary period. The other good option is to keep a portfolio well-diversified both in terms of source of return and risk.
Diversification in the era of rising inflation
The most important step that investors should take in times of inflation is to rebalance their portfolios by diversifying their holdings, especially by also including international and alternative assets. For example, while Western economies are experiencing a decline in the purchasing power of money combined with a sharp decline in the rate of growth, other economies such as the BRICS and other emerging markets, -whose growth rates have slowed but remain strong-, are experiencing stable cycles that continue to produce positive returns for investors. Building a portfolio that is diversified in terms of asset class, investment style and investment internationally can protect investors from the declining purchasing power of money and the value of investments in their home markets or geographic regions.
In an inflationary environment, investors need to incorporate both offensives (with equities) and defensives (with diversification) allocation strategies. In the past, bonds have been the main defensive allocation asset, but certain types of bonds have not always performed as well as expected in times of inflation. As another option to complement bonds, investors should consider some alternative strategies (including liquid alternatives) that pay an income. They can play a key role in maintaining a reasonable level of return and minimising losses within the portfolio.
Investors may also consider allocating to the so-called "exotic or niche" assets that withstand the turbulence of inflation by not only reducing the effects of inflation portfolio but can also help improve returns in times of economic uncertainty. Collectables such as wine, fine olive oil, art and other luxury goods or fine olive oil are among them.
Safe heaven assets as a hedge against inflation
There are a number of asset classes that investors have traditionally considered "safe havens from inflation". The most common potential safe havens are gold, commodities and real estate.
Real estate is seen as a traditional and mostly recommended hedge against inflation. because when inflation rises, property prices and rental yields tend to increase. thus in an economic scenario, with no immediate fear of rising interest rates and with central banks looking to stem any further economic downturn, real estate could have been an attractive option for investors.
Commodities are the other most common safe haven. Research has suggested that certain commodity sectors, notably energy (such as oil) or agriculture (such as milk), can be better investments to protect against inflation. Commodities can be used as a hedge against inflation because their prices tend to rise before inflation, as they are inputs into finished products. However, commodity prices can be extremely volatile, so some caution is recommended.
Gold is another safe haven that has long been considered the classic inflation hedge. As a real, physical asset, it tends to retain its value. But gold is not a perfect hedge against inflation, as it does not pay interest or dividends. It, therefore, comes with an opportunity cost, especially when interest rates are high. When inflation rises, central banks tend to raise interest rates, which affects the returns on other investments.
Stocks are a highly diversified asset class that can also serve as a hedge against inflation because of their long-term upside potential. Companies that perform well in times of high inflation tend to be lightly capitalised, which means they do not need a lot of resources to produce their product or service. For example, companies in the technology sector tend to be capital-light while companies in the resource sector tend to need a lot of machinery to extract and transform minerals, and are generally capital-intensive. When inflation rises, the cost of capital rises, which has an impact on free cash flow. Inflation is not uniform around the world, so a globally diversified equity portfolio can serve as a reasonable hedge against inflation.
Figure 2: Asset classes in the four inflationary regimes.
This figure shows the theoretical positioning of the different asset classes in each of the four inflationary regimes, and the heat map shows the position of these assets on the risk (volatility) spectrum. Depending on his/her risk and return profile, each investor can compose a structural diversification that suits him or her by choosing an allocation percentage for each asset to better balance and protect her/his portfolio in all seasons.
By investing in an inflation hedge the investors hopefully preserve (and potentially grow) the real value of their investment over time. But there is no perfect inflation hedge, as every investment is impacted by a range of factors beyond inflation. An increase in inflation will not automatically guarantee a corresponding increase in the returns of your inflation hedge assets.n the short term, any investment also carries risks, including the risk of losing capital. Whether you invest in gold, stocks, real estate, commodities or crypto-currencies, markets can move and turn against you. As safe haven, investors can keep their money in cash, which is the least volatile of all assets, but its real value is almost guaranteed to decline over time through currency erosion and the threat of currency devaluation.
Disclaimer: This article is provided for information purposes only and does not constitute an invitation to invest. Please seek advice from your investment advisor before investing.
Continued in Part 3: Investing niche assets and liquid alternatives as an inflation hedge