An inflation hedge is an investment that aims to protect against the effects of inflation.
Inflation causes the price of goods and services in an economy to increase over time. We measure it as the rate of change in a period that results in a decrease in the purchasing power of money over time.
Investing in an inflation hedge means investing in an asset you expect to maintain or increase in value over time, considering the impacts of inflation. It could also mean investing in an asset expected to decrease in value more slowly than an anticipated decrease in currency value.
A particular investment may appear to make a reasonable rate of return, but if the inflation rate is higher, the investment will lose value over time.
How does an inflation hedge work?
Say you have an investment that is returning 3% per annum. If the inflation rate is 4%, you effectively lose 1% of your investment's 'real value' each year.
Inflation causes a decline in the value of money over time, meaning the same amount of money loses purchasing power and will not be able to buy as many goods or services in the future. The effect of inflation can erode the actual value of your investments.
An inflation hedge attempts to protect against this erosion by seeking returns that are higher than the level of inflation. The ideal inflation hedge is an asset that will maintain or increase its value through periods of inflation.
Many companies use inflation hedges to keep operating costs low during periods when they expect higher inflation.
As the cost of inputs increases, companies may be forced to increase prices, cut their operating costs, or accept reduced profit margins.
For example, inflation can cause the cost of oil to increase. This is a significant cost for companies in fuel-heavy industries such as airlines. Aviation companies may go so far as to acquire oil refineries to reduce the risk of increases in the price of jet fuel. This means they can produce their own fuel instead of buying it from third-party suppliers at the market rate. They might also simply increase ticket prices.
What type of assets are inflation hedges?
An inflation hedge can be any safe haven asset with a return higher than the inflation rate. Examples include:
Gold
Investors have long considered gold a good inflation hedge. As a real, physical asset, it tends to hold its value. But gold is not a perfect inflation hedge as it pays no interest or dividends. This means it comes with an 'opportunity cost', especially with rising interest rates. When inflation increases, central banks tend to lift the interest rate, which flows through to the yields on other investments, and rising prices
Property
Property is another traditional inflation hedge. When inflation rises, property prices and rental yields tend to increase. Property doesn't just mean investing in family homes, either. ASX investors can gain access to commercial real estate, such as retail, office and warehouse properties, through real estate investment trusts (REITs)
Commodities
Commodities can be used as inflation hedges. The price of commodities tends to lift ahead of rising inflation because commodities are inputs into end products. Commodities comprise a broad range of materials, encompassing everything from iron ore to grain to oil and gas. Commodity prices can be volatile, so caution is advised for investors in this sector
Shares
Shares can also act as inflation hedges given their long-term upside potential. Businesses that do well in periods of high inflation tend to be capital-light, meaning they don't require heaps of resources to produce their product or service. Companies in the technology sector tend to be capital-light, whereas companies operating in resources tend to need a lot of machinery to dig minerals out of the ground. As inflation rises, the cost of capital increases, which in turn impacts free cash flow.
A globally diversified portfolio of shares can act as a reasonable hedge against inflation. This is because inflation is not uniform worldwide.
When Australia is experiencing a period of high inflation, other economies may be experiencing more stable cycles or economic growth that produce positive returns to investors over time.
Using exchange-traded funds (ETFs) is an easy and effective way to gain exposure to international shares.
What are the pros and cons of buying an inflation hedge?
The pro of buying an inflation hedge is that you hopefully preserve (and potentially grow) positive real returns of your investment over time. But there are also some potential drawbacks to consider.
There is no perfect inflation hedge, as many factors beyond inflation impact every investment. An increase in inflation will not automatically guarantee inflation protection through a corresponding increase in the returns of your inflation hedge asset.
There are risks involved in any investment, including the risk of losing capital. Whether you invest in gold, ASX shares, commercial property, or commodities, financial markets can shift and may move against you, especially in the short term.
Of course, if you keep your money in cash, it is virtually guaranteed that its real value will decline over time. That is one of the factors that makes stock market investing attractive to anyone with a surplus of cash.
