How you can hedge your portfolio against coming inflation

Inflation may be about to make a comeback. By how much and for how long remains a hotly debated question, but it's worth understanding how your portfolio might fare if it does lift and what changes you may need to make to guard against it.

At the most basic level, price inflation occurs when there's an increase in the price of goods and services, measured by the consumer price index (CPI). This can come from excess demand relative to supply, a shortage of supply relative to demand, or a combination of both. More than simply lifting the costs of your goods and services by a dollar or two here and there, inflation has wide-ranging ramifications on investment returns.

Flood of cheap money

If the prophets of doom are correct and inflation does strike, what will have caused it?

At this point it's hard to point to any one thing. For years economies around the world have received injections of cheap money, and lots of it.  Global cash rates have been low for a long time - for example, the US Federal Reserve has kept the federal funds rate below 3% since the GFC.

The rock-bottom rates are coupled with unprecedented quantitative easing programs, which have seen central banks buy back government bonds from the banking sector, thereby providing banks with more cash in their kitties to loan out into the economy.

Then, perhaps most importantly, there's US President Biden's $US1.9 trillion stimulus package.

The impact of inflation on investment portfolios will depend on how much it increases and for how long, yet experts are divided.

Leading the warning calls is Lawrence Summers, former director of the National Economic Council in the Obama administration.

For Summers, the impending risks hark back to the period immediately preceding the hyperinflation of the 1970s.

"As I look at $US3 trillion of stimulus, $US2 trillion of savings overhang, a major acceleration coming from Covid in the rear-view mirror, rates expected by the Federal Reserve to be at zero for three years even in a booming economy, record growth this year, major expansion of the Fed balance sheet, and much new fiscal stimulus to come - I'm worried," he says.

Others predict a temporary inflationary spike.

"Over the next several months, a combination of base effects, recent increases in energy prices, and price adjustments in sectors where activity ramps up is likely to push year-over-year inflation rates significantly higher," states a report by investment manager PIMCO.

"However, we forecast that much of this rise will reverse later this year as full employment remains elusive despite the expected strong labour market recovery."

In Australia, experts have more sanguine inflation forecasts.

AMP Capital chief economist Shane Oliver expects inflation will hit the Reserve Bank's 2%-3% target over the next year to 18 months.

"The risk is that we may see a period of overshoot given ultra-easy monetary policy now combined with reduced globalisation. Either way it will be higher than the last few years and consistent with higher bond yields than we have become used too."

David Bassanese, chief economist at BetaShares, is more optimistic. "It's still very likely that both Australia and the world will enjoy solid economic growth and falling unemployment rates over the next six months or so as we continue to shake off the Covid crisis. The question is whether strong economic growth per se will create inflation, which I doubt   due to very competitive conditions in both product and labour markets and ongoing technology disruption."

Assets under threat

To understand what needs to be done to guard against inflation, it's worth understanding which assets are most threatened by it.

Assets can withstand inflation if they, or the income streams they generate, appreciate in spite of it. In other words, you want a "real rate" of return. So, if an asset goes up by 1% annually but inflation goes up 2%, then the value of the asset has shrunk by 1% in real terms.

Far and away the asset class most under threat from inflation is fixed income.

"Today, you are lucky to get over 1% on a bank term deposit," says James Gerrard, director and certified financial planner at Financial Advisor.

"Not only is a 1% interest rate insufficient to meet the income needs of most in retirement, but when you also take into account the impact of inflation (which historically runs at 2.5%pa in Australia), many retirees are guaranteed to lose money on an inflation-adjusted basis each year in their term deposit and bond investments."

As Ray Dalio, founder of the global hedge fund Bridgewater Associates, puts it: "Cash is trash.   It looks like a low-risk thing to hold, but it's not. When you have a zero interest rate and an inflation rate of 2% or higher, you get taxed - essentially lose - buying power at 2% a year."

Investment-grade bonds are also left wanting during reflationary environments. Their fixed income stream via coupon payments has diminished purchasing power.

And it's not just the income stream - the value of existing bonds falls on the secondary market, eating away at the asset base of fixed-income investors.

And with a fall in bond prices comes an increase in yields.

"This would be negative for tech stocks (as they have long-duration earnings) and bond proxies such as utilities, telecommunication and property stocks," says Oliver.

Bulwark your portfolio

Hedging against inflation will require rotating out of some of the assets noted above. But you don't want to overdo it because assets that perform well during inflationary environments often don't do as well during low inflation.

"Don't lock your portfolios into a high-inflation environment and build just for that, because if you get that question wrong your portfolios will be incorrectly built and you'll lose out on return," says Kieran Canavan, chief investment officer at Findex Group, an Australasian financial advisory and accounting group. "But when inflation comes, you need to rotate your portfolio."

Because fixed income is the asset class most affected by inflation, so it makes sense to start there.

Bonds with shorter durations (the length of time between when a bond is issued and when the face value is paid back to the bond holder) are less susceptible to increases in interest rates - the standard central bank play to put inflation back in the box.

Moving to lower-duration bonds rather than to higher-yielding but low-quality bonds, is the way to go, according to Michael Abrahamsson, from Melbourne-based Flinders Wealth. "Short-duration, high-quality bonds provide some comfort versus long-duration lower-quality bonds," he says.

"From experience, lower-quality bonds provide higher interest rates for a reason, [with] heightened credit risk increasing the likelihood of default."

Other alternatives here could include inflation-linked bonds, which

have coupon payments that are adjusted in line with changes to the consumer price index.

However, ILBs are not a one-stop bond shop for guarding against inflation.

"The opportunity cost of investing in ILBs is that when other asset classes outperform, returns on ILBs are more likely to simply keep pace with inflation," says Abrahamsson.

Equities provide another good diversifier, to varying degrees depending on the length and strength of inflation.

Research from Schroders found that US equities perform best during low and rising inflation, outperforming 90% of the time during these phases. By contrast, US equities underperformed over half the time when inflation was above 3%.

"We find equities aren't good short-term inflation hedges, but they tend to be a good inflation hedge over the long term," says Canavan.

Additionally, "if you get rates going up because of growth, equity markets tend to be relatively resilient in that environment, but when you have rates go up because of monetary policy, you tend to get very wild swings."

Canavan prefers companies that generate rather than consume cash - price-setters with high barriers to entry, where you can increase the volume of sales without significantly increasing costs.

Commodity stocks, from oil to iron ore, have long been viewed as an effective inflation hedge given they largely contribute to, rather than shoulder, higher input prices.

Similarly, property offers a decent inflation hedge due to the pass-through of price increases in prices.

But gaining this exposure doesn't necessarily mean investing in property.

Gerrard points to first-registered mortgage investments.

"Several non-bank lenders allow external investors to participate in the loan deals they fund and typically pay interest less their clip, which is usually 1%-2%. Investors can expect 5%-7% interest in 50% loan-to-value ratio deals over first-registered property loan deals in metropolitan Sydney and Melbourne."

Then there's gold, which is adept at hedging without forgoing performance if things turn out to be better than expected.

"It's always been an inflation hedge. In the last nine months, there have been heightened concerns about inflation, and high inflation expectations are typically good for gold," says Jordan Eliseo, manager of listed products and investment research at the Perth Mint.

"The overall correlation between gold and equities is very minimal, but if you just look at when the equity market rises then gold is positively correlated in those environments - it just doesn't go up as much as equities do."

No single investment provides a panacea against inflation. Sure, you could put all your wealth into an asset known for its resilience during inflationary periods, but you would take on concentration risk. In this sense, the cure shouldn't be worse than the disease.

"Some asset classes traditionally recommended as inflation hedges might be quite risky under certain circumstances, especially when used as standalone solutions," notes research by Charles Schwab Investment Management.   "... a thoughtful, well-diversified approach is the most effective means to prepare for inflation."

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