Jhe US inflation rate reached 7.48% in January 2021, marking its highest level since the “great inflation” of the 1980s. Core inflation and core CPI in the US also exceeded 6% for the first time since September 1982.
Inflation represents a rise in the overall average price level of an economy and a decline in the purchasing power of the national currency of that economy. Rising labor costs and rising commodity prices are the two main drivers of inflation.
It’s important to note that inflation doesn’t just affect the price of consumer goods – almost any asset class can be affected by inflation in one form or another. While rising prices can be a sign of economic growth, translating into rising corporate profits and high stock prices, there is a flip side. As seen historically, rapid inflation prompts central banks to raise interest rates in an effort to control prices. Bond yields rise as prices fall, future corporate earnings are discounted more and stocks sell, and any floating rate credit product becomes more expensive.
If inflation sounds scary – and you can’t cope with inflation by switching to day-old milk – then you’ve come to the right place.
Here are seven of the best ways to protect your portfolio against inflation:
• ETFs and mutual funds outside the United States
• “Defensive” actions
• Bonds (including TIPS)
• Foreign currency
• Commodities (including gold and precious metals)
1. Non-U.S. ETFs and Mutual Funds
Inflation is generally seen as negative for stocks because it increases companies’ borrowing and production costs (materials, labor), further discounts their future earnings, and ultimately leads to higher expected earnings growth. weak. If U.S. corporate earnings are expected to decline, investments outside the U.S. can hedge a U.S.-dominated portfolio and capture potential returns from global markets where inflation may not be as high.
Examples of ex-US ETFs:
Vanguard FTSE All-World ex-US ETF (VEU)
ETF SPDR Portfolio Non-US Developed World (SPDW)
iShares MSCI ACWI ex US ETF (ACWX)
iShares MSCI ACWI ex-US ETF (CWI)
Examples of old US mutual funds:
Fidelity Global ex-U.S. Index (FSGGX)
Vanguard FTSE All-World ex-US Admiral Index (VFWAX)
State Street Global All Cap Equity ex-US Index (SSGVX)
According to diversification theory, the less correlated two investments are, the more they can protect investors from downside risk. Although diversification is generally considered across asset classes, it also applies geographically, in this case increasing weightings of positions outside of the United States.
2. “Defensive” actions
Although higher inflation usually leads to Fed rate hikes which can hamper stock returns, some sectors act as a hedge since they tend to appreciate at such times. Materials and Utilities are two defensive sectors that investors often turn to. When commodity prices rise, materials stocks follow their course. As for utilities, the average stock in this sector carries the second highest dividend and the lowest beta of the eleven sectors. Therefore, many utility stocks act as a kind of hybrid bond, sporting the risk elements of fixed income instruments with the ability to generate current income via dividends.
3. Obligations, including TIPS
The Federal Reserve raises the federal funds rate as a means of controlling inflation and, in turn, raises interest rates in all periods. During periods of inflation, investors might consider increasing their positions in fixed income securities, as higher risk-free yields make bonds more attractive relative to risky assets such as stocks. But beware: timing is everything. Buying bonds after rate hikes have been priced in is one thing, but buying them before a rise in rates could lead to a depreciation in the value of these bonds.
Treasury yields are usually one of the biggest beneficiaries of rate hikes, as seen most recently in 2016 and early 2022.
Another fixed income vehicle, treasury inflation-protected securities (TIPS), are similar to treasury bills but are designed specifically to protect against inflation. Just as treasury bills fluctuate with interest rates, TIPS managers appreciate when inflation rises, as measured by the consumer price index. During periods of inflation, TIPS can provide additional returns and protection to a portfolio if or when stock prices dip. TIPS are available in terms of 5, 10 and 30 years.
4. Foreign currencies
Inflation not only decreases the purchasing power of a currency domestically, but it can also weaken a currency against the bidding of other countries. Although a weakened currency can stimulate foreign buyer activity, holders of that currency are at a disadvantage when buying from foreign countries. For example, the US dollar experienced relative weakness against the pound, Canadian dollar, euro and Australian dollar from March 2020 through the first half of 2021, in part due to rising inflation. But then, as inflation spread to the rest of the world, the US dollar strengthened again in the second half of the year.
The Japanese yen has often been considered a safe haven for US dollar holders during times of economic uncertainty. Japan’s historically stable economic growth and inflation rate have resulted in moderate fluctuations in exchange rates, providing protection against inflation-induced currency devaluation.
Those wishing to diversify entirely outside of fiat currencies might seek other stores of value. An emerging asset class is cryptocurrency, including Bitcoin, Ethereum, and Cardano. While it may be too early to call cryptocurrencies reliable inflation hedges, their broad appeal as a decentralized store of monetary value is growing in popularity.
US investors can participate in the crypto craze by directly owning coins or buying shares in crypto trusts or ETFs. Some of those available on YCharts include Grayscale’s Bitcoin (GBTC), Ethereum (ETHE), and Litecoin (LTCN) trusts, as well as the ProShares Bitcoin Strategy ETF (BITO).
For a deeper dive into all things crypto, read what Onramp CEO Tyrone Ross has to say about why advisors should think about crypto assets.
6. Gold, precious metals and commodities
All that glitters is gold, especially in times of inflation.
Precious metals such as gold have been historical favorites for inflation protection due to their scarcity, tangibility and historically negative correlation to paper money.
In addition to owning physical gold, investors can consider adding gold miners, ETFs, or even currency-hedged gold funds to their portfolios to “stay golden” through inflation. Some of these coins include SPDR Gold Shares (GLD), iShares Gold Trust (IAU), VanEck Vectors Gold Miners ETF (GDX) and Aberdeen Standard Gold ETF (SGOL).
Other tangible assets include commodities, such as oil, timber, and steel, the prices of which not only rise with inflation, but also act as indicators of future inflation and economic growth. As the economy expands, demand for commodities heats up, pushing their prices higher.
7. Real Estate
Like precious metals, real estate is a tangible asset that tends to retain its value in times of current inflation. As prices increase, property values and rents also increase, which increases the amount of rental income earned as well as the book value of the property.
Existing owners may actually welcome inflation because it translates into more valuable equity. However, property taxes could increase in kind. If you’re considering buying a home for the first time, rising house prices might make you doubt that corner lot in the suburbs.
Alternatively, the benefits of owning real estate can be captured by adding real estate investment trust (REIT) holdings to a portfolio. REITs typically operate real estate conglomerates and are owned by investors. These investors receive distributions from the REIT’s rental income, interest and real estate sales. There are hundreds of REIT stocks, ETFs and mutual funds available on YCharts in addition to general real estate securities such as the SPDR Select Real Estate Sector ETF (XLRE).
Whether at the grocery store or on the road, consumer demand and healthy economic activity (but sometimes money printing and resource scarcity) trigger inflationary effects and push prices up. Although consumers and investors have good reason to be concerned, there are many ways to protect long-term investments against the forces of inflation. Whether it’s investing outside the US or acquiring gold and real estate, the ability to hedge your portfolio against inflation should allow you to sleep well at night.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.