Hey, it’s Bruce. Since my last post, I’ve been busy trying to learn more about keeping up or even outpacing high inflation rates. Yes, the fear of allowing my cash to continuously lose its value because of inflation is real. For me, at least.
I have previously written about some simple steps most of us can take to try and protect the value of our dollar from being eroded by persistent inflation. This time, however, I would like to focus on this from an investing point of view.
Unpacking this subject was really tough, given the numerous asset classes available to invest in. Additionally, there are differing viewpoints on the type of investments that can be considered a good hedge against inflation. You see, not all investments are created equal, and there is no predicting the future with full certainty. We have past data on the performance of certain assets against inflation rates, which is by no means indicative of future performance.
And while the internet was abundant with information on inflation hedges, I found it overwhelming to process. As such, I decided to enlist the help of several experts and industry veterans in hopes that they could enlighten me on the subject. Armed with my curiosity and desire to learn, I decided to reach out to them with some simple questions. To my surprise, I received some insightful comments and views in response which I will gladly share with you all here.
First things first, what is an inflation hedge? An inflation hedge is an investment that could protect the value of your money from being eroded by inflation, either by maintaining or increasing in value over time. In other words, an inflation hedge is an investment believed to have the potential to yield enough returns to offset any loss in currency value from inflation.
Common investments that have been said to be good hedges against inflation include stocks, bonds, gold, commodities and real estate. These are broad asset class categories that require a deeper dive before determining what could work out to be a good hedge against inflation.
In the past, precious metals such as gold and inflation-linked bonds would have performed well in an inflationary environment. However, 2022 was a year that completely defied conventional wisdom. As Wilfred Lim, Head of Strategy for Investment Solutions at Phillip Securities explains, this was due to a “quick surge in inflation, leading to aggressive rate hikes globally. As a result, every asset class saw huge declines with the exception of commodities, which was the main cause of inflation in the first place.”
Supporting that view is Freddy Lim, Co-founder & Chairman of Investment Committee for wealth management platform StashAway, who elaborated that “Russia’s invasion of Ukraine exerted enormous pressure on an already strained global supply chain leading to rise in food and energy prices. So crude oil and energy stocks became the few investments or inflation hedges that outperformed inflation in 2022.” Crude oil and energy stocks gained 40.5% and 64.2% year-to-date in 2022 respectively, at the time of writing.
We need not look further than the performance of gold to see how 2022 greatly differed from the norm. Gold has been used as a form of currency and as a store of value since time immemorial. As an inflation hedge, historical data has shown that gold’s price tends to keep up with average inflation rates, which is how it has earned its reputation as a classic inflation hedge.
However, gold did not do so well in periods of above-average inflation or when there was a sudden spike in inflation, such as what we saw in 2022. “Global central banks were playing catch up to inflation, and substantial rate hikes were conducted. This in turn interfered with gold’s ability to perform as it is sensitive to interest rates,” said StashAway’s Freddy Lim.
“There’s a bit of a misnomer with what we were taught about gold conventionally. Gold is actually more of a hedge against the debasement or devaluation of fiat money. From this perspective, it is easier to see why gold’s ability to function as an inflation hedge was compromised when central banks were hiking rates aggressively. As rate hikes take rates higher, it is also becoming more attractive to park your deposits in fiat money. Back in January 2021, we were earning a meagre 0.3% in 3-month USD deposit, but the yield is now 4.6%,” Freddy explained.
Phillip Securities’ Wilfred Lim added that when taking into account interest rates, “it is better to look at gold as a hedge against deeply negative real interest rates.” “This happens when inflation is greatly higher than the Federal Reserve rate. In 2022, although inflation was high, the Fed increased rates aggressively as well, leading to the underperformance of gold,” said Wilfred. “Using gold as an inflation hedge should be analysed in conjunction with interest rates and other economic factors,” Wilfred concluded.
The stock market often takes a beating during periods of sustained high inflation, as seen in 2022. Historically, however, the returns on stocks have outpaced inflation by a significant margin over a longer investment time frame. “Of the four main asset classes, shares have outperformed inflation over the long term. In the short term, any one of the asset classes, namely, cash, bonds, property and shares, could do well (as inflation hedges). But over the long term, it should be shares,” said David Kuo, Co-Founder of investment education website The Smart Investor.
That being said, stocks are a broad category of assets comprising many various sectors. Not all sectors will perform the same against inflation. “The rate of inflation should abate, given the aggressive stance of central banks around the world. This could result in a stock market shakeup in which the strongest will survive, and the weakest will wither. The key for investors is to invest only in the strongest companies,” said David.
So, how do we know which companies or sectors would make for great inflation hedges? Clues can be found by applying some common sense and a basic understanding of behavioural economics. The consumer staples sector, which consists of companies that are in the business of providing goods and services that people use on a daily basis, tends to do well in high inflationary periods. I can think of food and basic hygiene products.
Other examples of sectors that tend to outpace inflation include healthcare and utilities. This is simply because these services are required by people regardless of the bad economic climate.
Another interesting sector during high inflationary periods is finance, particularly banking and insurance companies. As central banks hike rates in response to inflation, bank interest rates would go up as well. This allows banks to gain higher profit since they can now charge higher interest rates on loans that they give out. Similarly, insurance companies also become more profitable as interest rates go up because they can make more money from clients who reinvest their premiums.
Another popular asset class for hedging against inflation is real estate. In the past, the value of property increased during periods of high inflation. This then leads to property owners and landlords increasing their chargeable rent and making more money. The most straightforward way to invest in real estate is of course to purchase your own home. But that isn’t for everyone, and people do purchase homes to live in as opposed to renting them out.
An alternative way to get into real estate investing is to invest in Real Estate Investment Trusts or REITs for short. REITs are basically real estate stocks that allow you to own a piece of the underlying properties in the fund through shareholding. REITs make real estate investing much more accessible given that it is more liquid and easier to purchase or sell. REITs are also required to distribute at least 90% of their income as dividends to shareholders, making it a good strategy for passive income play.
But what about using REITs as an inflation hedge? I asked independent financial advisor Kenny Loh if he thought that REITs make for a good hedge against inflation, and his answer was “yes and no”. He explains that “the underlying assets of REITs are physical real estate and REITs rely on rental income generated from the space rented out. In theory and in a very simplistic way, the valuation and the rental income of the underlying real estate go up in the long term due to inflation.”
“However there are many variables which affect the valuation and rental income of the properties. The valuation of the property would be determined by the land lease tenure, the age and quality of the building, demand and supply of the competing rented space of the surrounding properties, etc.” Kenny elaborated.
“REITs as a good inflation hedge is only true when the REIT in question has shown a track record of sustainable and steady growth in Net Asset Value (NAV) and Distribution Income (shown in Distribution Per Unit, DPU) over the long term. The share price has a positive relationship with the NAV & DPU over the long term,” he said.
While researching inflation hedges, I came across something that piqued my curiosity: alternative investments. This includes investing in assets such as wine, whiskey, and art. How could these items possibly gain capital appreciation, let alone outpace inflation? The All Art Index, which tracks the sale of art across 130 auction salerooms worldwide, gained a staggering 35% in 2022. Meanwhile, the Rare Whisky Icon 100 Index had an 8.19% return in 2022, while the Liv-ex Fine Wine 100, which represents the price movement of 100 of the most sought-after fine wines on the secondary market, gained close to 7% in the same year.
StashAway’s Freddy Lim opined that “despite already having a stellar year back in 2021, the global fine wine investable market returned close to 21% in 2022, according to the “State of the Wine Industry Report 2022” by Silicon Valley Bank.”
“I think the long-term outlook for investables in fine wine and whiskey remains a positive one. What I really like about fine wines and whiskey is their low correlation to the global stock market,” said Freddy.
Phillip Securities’ Wilfred Lim was more cautious with his view, noting that these types of investments “can be great inflation hedges, but each carries its own set of risks which requires specialised knowledge to mitigate. Common risks include survivorship and counterparty risk.”
Aside from the aforementioned investments, there are plenty of other investment options that some investors believe to be good hedges against inflation. There are plenty of differing opinions on what makes a good inflation hedge, and no one can really predict the future with certainty. I do think however that investing your cash for the long run is a step in the right direction. Phillip Securities’ Wilfred Lim sums it up nicely: “Historically, holding on to cash has been a poor form of inflation hedge. So unless deflation happens, it is wise to stay invested in fundamentally sound assets to hedge against inflation.”
I hope that the list above has at least given you a good place to start.
Sources: Forbes, The Motley Fool (1)(2)(3), Rare Whiskey 101, Liv-ex, Art Market Research, CNBC