Hedging Inflation: Definition, Limitations, and Investment Strategies

Anyone driving or shopping these days understands inflation intuitively. The cost of everything from gasoline to groceries has climbed and is set to rise further through 2022. Inflation, or the loss of money’s purchasing power, has become a topic of constant national conversation.

Investors worry about inflation because it erodes the real value of investments, as well as the value of income generated from those investments. So in times of high inflation, there tends to be more interest in investments that compensate for inflation’s effects, called inflation hedges.

What is an inflation hedge?

Inflation hedging is a strategy for investing in assets that have a higher probability of keeping up with the rate of inflation, perhaps even generating returns exceeding inflation. The main point of such a hedge is to keep investors from falling behind the rate of inflation, or getting swamped by it entirely. A smart inflation hedge can help an investor maintain their annual income and a standard of living, or preserve the value of their retirement or savings funds.

Some investments, such as bonds, are particularly vulnerable to inflation. That’s because most bonds pay a fixed rate of interest, so if inflation exceeds the bond interest, the investor ceases to make money on that bond investment. In mid-2022, the going rates for U.S. Treasury 10-year bonds are under 3%. Bank certificates of deposit and annuities also are vulnerable to inflation, as they pay only modest rates to investors–less than 1% for most CDs and about 4% for most annuities. All of these yields do not keep up with the current rate of inflation, which is about 7%.

Inflation hedging strategies can be designed to cover broad risks in a portfolio of investments (called macro hedging),  or to protect a specific investment (micro hedging).

• Macro hedge.

  This reduces the risk of losses from macroeconomic shifts or risks, such as slowing economic growth, central banks raising interest rates, or countries devaluing currencies. A macro hedge often involves an investment position that moves inversely to the hedged asset. For example, an investor who owns bonds and expects rising interest rates to reduce the bonds’ market value, may short sell Treasury-bond futures, profiting from the short sale to offset a loss on the bonds. A diversified stock portfolio similarly could be hedged by short-selling futures on the S&P 500 Index, for example. Macro hedges generally are for sophisticated investors like professional traders and fund managers. They require large amounts of capital and familiarity with an array of financial instruments including derivatives. For small investors who are interested, some macro-hedging ETFs are available. ‍

• Micro hedge.

  This mitigates the risk of loss in a specific investment, such as shares of a company. For example, an investor in Company X who is concerned about the company’s near-term outlook might buy a put option to guarantee a floor price for their shares. They might also buy shares of another company whose returns historically are not correlated with Company X. 

Limitations of inflation hedges

Inflation hedges come at a cost. Investors must buy derivatives, and they also must establish margin accounts with capital requirements. There are also margin interest costs since hedges are often leveraged and investors buy the derivatives on margin. The return on a hedge position ought to at least match the margin interest rate, in order for the investor to break even.

Hedges can also have their own volatility. The asset classes commonly favored as inflation hedges, such as U.S. stocks, emerging market stocks, real estate and commodities, often have larger price swings than more stable investments such as bonds.

Unless inflation is chronic, hedging may be a fitting short-term strategy but not a long-term one. Once inflation is under control, investors may want to close out any inflation hedges if they are no longer useful.

Common inflation hedges

There are many types of investments that are commonly used to hedge against inflation.

• Stocks.

  In the past century, the stock market has had average annual returns of about 10%, making it a long-term investment that has beaten inflation. During inflationary periods, investors might buy non-cyclical stocks–companies that generally succeed through good and bad times in the economy’s cycle. Stocks of staple consumer goods, food processors, utilities, and health care and pharmaceuticals are some examples. Sector funds and ETFs provide investors a way to try a non-cyclical focus.‍

• International diversification.

  A greater allocation to foreign stocks and bonds may help cushion against the effects of inflation, as some countries such as Australia and South Korea have economic cycles that don’t correlate with the U.S. economy. Emerging markets such as Brazil and Poland also may offer a hedging opportunity.‍

• Real estate.

  For many investors, this is available mainly through real estate investment trusts (REITs) or ETFs, which hold an array of properties and mortgages, or invest directly in property. Real estate provides an income stream through rents, passed through as REIT and ETF dividends, and in inflationary periods, rents and property values often rise.‍

• Commodities.

  Agricultural, energy and industrial metals tend to track inflation, as they are used in products and services that make up the Consumer Price Index (CPI), which factors into the inflation calculation. Also, long-term correlation of commodities to stocks is low, giving investors more diversification in their stock portfolios. Gold is often regarded as the inflation hedge of choice among commodities.‍

• Inflation-indexed bonds.

  These bonds are designed to rise in value with consumer inflation, such as the CPI in the U.S. The interest rate is typically lower than for conventional bonds, while the bonds’ principal value is adjusted higher to compensate investors. The best example is Treasury Inflation-Protected Securities (TIPS), which are sold by the U.S. government. Many other countries also sell such bonds. ‍

• Direct lending.

  These are loans to private, middle-market companies, known as private-credit investing. These loans charge a floating rate that adjusts higher for inflation, so have higher yields as interest rates rise, and are also fully backed by company assets as collateral. Small investors have access to direct lending via ETFs specializing in bank loans. 

Can investors profit from inflation?

Hedges are meant generally to contain inflation. Nevertheless, they may be used by investors to attempt to beat inflation, depending on the types of investments they choose—stocks, real estate, commodities, inflation-protected bonds. It all depends on whether the returns on the investment chosen is higher than the rate of inflation.

Stocks may still be the best bet, mainly because companies are continually driven to maximize profits by cutting costs and increasing sales. As a result, investors generally have higher expectations for returns on stocks than other asset classes, regardless of general economic conditions. In addition, companies with established dividends and dominant market share in their industries can increase dividends over time.  

The bottom line

Hedging can be a short-term approach to dealing with inflation. In the long term, though, investors may wish to focus on the goal of increasing wealth through assets with the highest historical average growth rates. Once inflation has abated, investors might consider winding down their inflation hedges.