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How can traders hedge against inflation?

Published 21/02/2022, 16:21
Updated 21/03/2024, 11:50


As inflation measures the rise of the price of a shopping basket of goods and services representing the average consumption of a household in a given economy, it represents the declining purchasing power of the relevant currency.

It also means that inflation has the effect of reducing the value of real profits you could make with your investments. With US inflation reaching a 40-year high (CPI up 7.5% over year ended January 2022), investors are spooked about what recent fast rising prices could do to their investment portfolios…

But serious investors aren’t standing still in the face of runaway inflation, they’re thinking about the best ways to adapt their portfolios to this new macroeconomic environment, so they can protect their investments with inflation-hedged assets that truly help their positions thrive in this inflationary climate.

Let’s now have a look at the most common inflation hedge practices and investment products.

Diversify your stock portfolio internationally
Investing in equities has long been a traditional way to hedge against inflation over time, as companies are often able to offset rising input costs by increasing the price of their goods and services. Stocks also pay dividends that usually grow over time.

While high inflation seems to be noticeable in most major economies due to rising labor costs and commodity prices, as well as global transportation troubles and supply chain bottlenecks, not all countries are impacted in the same way as the United States. This means that not all central banks might respond as quickly and decisively as the Fed to fight inflation.

Diversification is key if you want to build a strong portfolio over the long term that effectively hedges against inflation, so think about international stocks across different sectors and in different currencies. You can also take advantage of short-term volatility triggering bullish and bearish moves with derivatives like share trading with Contract For Difference (CFDs).

Look to real estate
Whether you’re thinking about real estate values or rental incomes, they both remain resilient in an inflationary environment, as they adjust upwards with inflation, which means that real estate can be a great way to hedge against inflation.

If you don’t have enough capital to buy a property, you can invest in real estate through different products like Exchange-Traded Funds (ETFs), Real Estate Investment Groups (REIGs), or Real Estate Investment Trusts (REITs).

Consider Gold
Gold is a classic inflation hedge asset. When inflation is very high and central bank actions aren’t clear enough to investors, gold is often considered a safe-haven asset to fight financial uncertainty and market volatility.

While physical gold might not be the best option due to the added costs associated with protecting and storing it, you can rely on other options, such as buying stocks of mining companies or trading ETFs on precious metals or exclusively on gold.

It is important though to realize that with strong inflation, central banks are more likely to increase their main interest rate, which means that holding gold might not be as profitable as holding other assets that pay yields.

Turn to floating-rate bonds
Traditional bonds tend not to perform well during periods of high inflation, as their price usually falls due to newly issued bonds offering higher yields. With higher inflation, you have to bear interest rate risk if you have to sell your bonds before the maturity date. Bondholders also have to deal with coupon payments worth less than before because of a loss of purchasing power.

However, there are some bonds you can use to be protected from inflation, like Inflation-Linked Bonds (ILBs) such as Treasury Inflation-Protected Securities (TIPSs). Because they are indexed to inflation, these products keep pace with inflation, which means that the value of your investments is relatively safe.

Rely on equities that can drive capital appreciation
Not all equities are equal when inflation increases. Some sectors tend to thrive in an inflationary environment, while others generally underperform.

For instance, value stocks generally outperform growth stocks in high inflation periods. According to Goldman Sachs , cyclical stocks are also well-suited to when prices are increasing in an economy that’s doing well or recovering, while defensive stocks might underperform in such an environment.

Pharmaceuticals, health insurers, and other related sectors in the health industry, as well as financials, energy, real estate & infrastructure, utilities, and consumer staples tend to outperform when inflation rises. Ideally you should focus on companies that are able to maintain their margins, as well as pass along cost increases.

Conclusion
We’ve seen some of the most popular safeguard investments against inflation, but there are other tools you can use depending on your trading style, investment horizon, capital, as well as financial goals. Always remember to have a well-diversified and balanced portfolio to avoid overloading it with any one investment option we’ve mentioned.

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