How to Hedge against Inflation: Methods and Tips

Information is not investment advice

Inflation doesn't come from nowhere. There’s always a reason for it to occur. Moreover, it’s often happening because of human mistakes and biases. All we can do is prepare ourselves and withstand inflation risks and consequences. This crash course touches on inflation reasons and ways to protect from it.

What is Inflation?

Inflation measures the rising prices of goods and services in an economy. When inflation occurs, it leads to higher prices for necessities such as food. Most of the time, inflation doesn't help the economy and only makes things worse for people. But where does it come from?

Various factors can drive prices or inflation in an economy. Typically, inflation results from an increase in production costs or an increase in demand for products and services. Also, one of the signs of inflation may be rising commodity prices such as oil and metals. However, several researches deny this correlation. Check our article on the link between oil and prices to level up your oil understanding.

One of the most significant inflation drivers is the so-called "Black Swans." They are improbable events that have an extremely strong impact on the economy. It can be a war, natural disaster, or a pandemic, like the one that started in 2020. Black swans disturb the supply chains, decreasing the number of goods on the shelves and boosting prices. After the start of Covid-19, the US Federal Reserve printed more than 8 trillion dollars in less than two years. That put the world on the brink of an economic crisis, and it’ll likely start in less than a year.

Source: Bloomberg

Inflation decreases the purchasing power of currency due to a rise in prices. A predictable response to declining purchasing power is to buy now rather than later. Cash will only lose value, so it’s better to get your shopping out of the way and stock up on things that probably won't lose value. For people, it means buying more now so that they can buy less later. And for businesses, it means making more investments that’ll be way more in the future. Let's learn how to avoid inflation in every possible way.

How to Hedge Against Inflation?

There’s a number of ways how you can take advantage of rising prices. We’ll put them down one by one.

Short-term Bonds

These instruments have a lot in common with money market securities, so let's take care of them first. Money market securities consist of cash investments, short-term debt securities (US Treasuries), and cash equivalent securities. Investors consider them the safest asset group with high liquidity and low volatility. To make things clear, let's put one more explanation here. A bond is a security issued by a government or corporation to gather more money for their projects and activities. Bonds have lower risks compared to stocks but provide less profit.

What about short-term bonds? A government or a corporation usually issues them. Short-term bonds provide less yield compared to long-term ones. However, long-term bonds tend to be ineffective when high inflation comes because rising prices reduce the value of payments. For example, you have a long-term bond, and it generates you $100 every year. But with a 10% inflation rate, you would buy 10% less every year, and you can do nothing about it. Short-term bonds are more resistant to inflation as they expire quicker. Still, we don't recommend you hedge against inflation with bonds as they often give negative annual returns amid high inflation.

Stocks — Long-term Insurance Against Inflation

The next on our list is shares (stocks, equities). While the bond market may seem confusing, the stock market is powerful enough to save you from inflation. Historically, stocks are outplaying inflation in long periods (10 years and more).

As you can see, US equity (stock market) gave the biggest total return over the last ten years. We agree with the estimation above; statistically, stocks are performing well and if you want to save your money from inflation, invest in stocks. We suggest looking for companies always favored by the market, like retail and commodity extracting companies and banks. With FBS, you can invest in Alcoa (ALCOA), 3M (MMM), McDonald's (MCDONALDS), JPMorgan (JPM), and many more. Check them all on the Stock Trading page.

Gold During Long-term Inflation

Gold is a haven asset, which means that people trust gold. The motives behind this faith are understandable: there’s a limited amount of gold in the world and an unlimited amount of money. And this is the reason for the constant growth of gold. It’s the measure of inflation. Depreciation of money means that you can buy less with the same amount. And now make a cross-reference with gold, the amount of which isn't increasing so fast.

Usually, gold price is rising in line with inflation, so it’s one of the best assets for you in the periods of increasing prices. However, notice that gold is not rising simultaneously with the prices. There’s a time lag between them, so gold is an efficient inflation hedge for long periods.

"TIPS" — Treasury Inflation-Protected Securities

Treasury inflation-protected securities (TIPS) are a type of Treasury security issued by the US government. TIPS are indexed to inflation to protect investors from a decline in the purchasing power of their money. Basically, it's a bond (obligation) that rises with inflation, and bond payments vary according to the change in the bond's principal (initial) value.

You get TIPS payments twice a year and can buy them from a bank. In addition, you can choose between holding your TIPS till it matures (closes) or selling it beforehand—the US issues TIPS with different lifespans, from 5 to 30 years. Let's look at the returns of inflation-protected securities.

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Even TIPS suffers from rising prices: the chart has been falling for almost a year. We wouldn't recommend you to seek inflation protection in this asset.

Commodities

We’ve touched gold in this article already, so let's focus on a different yet crucial commodity – oil. An increase in oil prices usually lowers the expected economic growth rate and increases inflation expectations over shorter horizons. Decreasing economic growth prospects, in turn, reduces companies' earnings expectations, resulting in a dampening effect on stock prices. But that's in theory.

There’s no clear evidence that rising prices are a bullish factor for oil. In our article "Oil can reach $100; what does it mean for markets and inflation?" we touched on the theme, be sure to check it out.

Oil reacts to supply and demand ratio, logistics concerns, and the pace of economic growth. It can be a decent choice if you want to save your money but only when the economy is feeling good. Rising prices themselves don't boost XBRUSD or XTIUSD. On the other hand, the growing level of goods consumption boosts oil. It's wise to invest in oil when the economy finishes a recession.

Cryptocurrencies

Cryptocurrencies are pretty volatile, and their correlation with different assets often changes. Still, some cryptos can work as an inflation hedge, but you need to choose wisely. The best inflation-protected cryptos are those with controllable inflation. For example, Bitcoin has annual inflation of 1.25%, which will decrease over time. Ethereum has less controllable inflation due to the nature of this crypto. However, Ethereum is a deflationary asset most of the time, meaning that the coin's supply decreases.

The cryptocurrency market is relatively young and didn't witness major economic crises. This year will show us what opportunities crypto provides.

Leveraged Loans

A leveraged loan is a type of loan given to companies or individuals who already have considerable debt. It’s like the leverage of a Forex broker but in real life. More investors draw their funds to a leveraged-loan market amid rising interest rates. Following $27.8 billion in stock outflows in 2020, $13.1 billion re-entered the leveraged loan market in the first quarter of 2021.

Leveraged loans can provide you with a defense against inflation because they negatively correlate with 5- and 10-year Treasuries. So they are cheaper when the market is pricing in the recession. It's possible to take a leveraged loan while it's cheap and invest the money in any haven asset you love the most (for example, gold). Please think twice before entering the world of leveraged loans as they are risky instruments.

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What is Inflation?