In April 2022, wholesale inflation surged to a record 15.08 percent due to the hardening of prices prompting the RBI to increase interest rates in its June Monetary Policy Review. In the coming months, higher wholesale inflation is expected to trigger retail inflation which also hit an eight-year high at 7.79 percent in April.
No one likes high inflation. So what can an investor do to hedge against this rising inflation and what can protect their portfolios?
What should a good inflation hedge have?
It should be able to quickly respond to high inflation. For example what if one’s salary was not fixed but were to receive an inflation-adjusted salary? This means if and when inflation was to go up by 5% beyond an acceptable level then his salary also increases by 5%. Sure it sounds impractical but that’s what one would look for in an inflation hedge.
The second characteristic of a good inflation hedge is that it should work reliably across different time periods, geographies, and inflation regimes. Inflation is perceived as a demand-led phenomenon i.e. if there is more demand for a product, then the price goes up. But inflation can also be supply-driven like what we are seeing now with a shortage of food grains, semiconductors, and palm oil.
The third characteristic of a good inflation hedge is its ability to deliver reasonable long-term returns.
Let us look at the asset classes that can be the best hedges for inflation.
According to a study on the US markets by ET Money, energy as an asset class delivered an average of 41% returns across the 8 high inflation periods that haunted the US from 1926 to 2020. The Nifty’s more recent performance does exhibit a similar trend with the Nifty Energy Index being the highest performer amongst all indices for the year 2022. But a point to remember is that during periods of supply-driven inflation we have seen the best returns from energy investments.
Since 1971, the price of gold has grown by about 50 times and so has inflation and it is this apparent correlation between gold and inflation that has led many to believe that gold is a good inflation hedge.
It is true that gold has shown signs of delivering high performance in times of high inflation. It did so in the 1970s when it delivered an average real return of 130% while US stocks delivered a negative return of 12% per annum during that same period.
From an Indian context and as per the World Gold Council, for every 1% rise in inflation, the demand for gold in India soars by 2.6%. It was observed that when the inflation rate crosses 8%, gold tends to beat equities, bonds, and treasury returns.
Traditionally, real estate assets have been considered good hedges for inflation as their value increases with inflation. But real estate, unlike gold or energy, does not offer a high real return whether one buys property or invests via a real estate investment trust. This is because the sector goes through massive boom and bust cycles as a result of which the risk-reward ratio becomes a little lopsided for investors.
Equities have always been investors’ favorite hedge against inflation. It is also true that inflation does eat into one’s equity returns as we can see when inflation crosses the 10% mark. The impact of different equities on high inflation is quite different. For example, coal, oil, steel, chemicals, and electrical equipment do well in high inflation whereas, consumer goods, automobiles, restaurants and hotels, and retail are generally the losers.
For long-term investors, their equity investments are likely to beat inflation but for short-term and for tactical investors it makes sense to do more research before considering equity.
Money tends to lose value with time, alongside, the extent of inflation in the economy varies with current events. However, there are multiple routes for investors to hedge against inflation, including investments and inflation-hedged asset classes designed particularly for that purpose. Keeping these assets on your list, and acquiring them at the time of inflation, can create room for your portfolio to thrive despite the economic climate.