What is an inflation hedge?
An inflation hedge is an investment aiming to protect against the effects of inflation. Inflation is the decrease in the purchasing power of money that occurs as the price of goods and services increases.
Investing in an inflation hedge means investing in an asset that is expected to maintain or increase in value over time, taking into account the impacts of inflation. It could also mean investing in an asset expected to decrease in value less quickly than an expected decrease in the value of currency.
A certain 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 rate of inflation is 4%, you are effectively losing 1% of the real value of your investment each year.
Inflation causes a decline in the value of money over time, meaning the same amount of money will not be able to buy as many goods or services in the future. The effect of inflation can erode the real 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 in order to keep operating costs low during periods when they expect inflation to be high.
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 major cost for companies in fuel-heavy industries such as airlines. To reduce the risk of increases in the price of jet fuel, aviation companies may go so far as to acquire oil refineries. 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 asset that provides a return higher than the rate of inflation. Examples include:
- Gold has long been seen as the classic 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 when interest rates are high. When inflation increases, central banks tend to increase interest rates, which flows through to the yields on other investments
- Property is another traditional inflation hedge. When inflation rises, property prices and rental yields tend to increase. Property doesn’t just mean family homes, either. ASX investors can gain access to retail, office, warehouse, and other types of property through real estate investment trusts (REITs)
- Commodities can be used as an inflation hedge. The price of commodities tends to rise ahead of increases in inflation because commodities are inputs into end products. Commodities comprise a very 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 can also act as an inflation hedge given their long-term upside potential. Businesses that do well in periods of high inflation tend to be capital light, i.e. 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 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) the real value of your investment over time. But there are also some potential drawbacks to consider.
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 on the returns of your inflation hedge assets.
There are risks involved in any investment, including the risk of losing capital. Whether you invest in gold, ASX shares, property, or commodities, 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 factor that makes investing attractive to anyone with a surplus of cash.
Last updated 6 April 2022. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.
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