How to hedge against inflation

Global markets recently faced a correction, inflation remains above the 2% target and interest rates are likely to rise, but how can investors prepare?

How to hedge against inflation

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During these times of uncertainty, the big concern is how investors should be positioning their portfolios and how can they hedge against inflation?

January’s consumer price index (CPI) data revealed that inflation remained at 3%, defying the consensus view that it would marginally dip to 2.9%. Having now remained above the Bank of England’s (BoE) 2% target for 12 months in a row, investors may ponder where their money is best placed.

David Hooker, lead manager of the Insight Inflation Linked Corporate Bond fund says if wages and domestic prices go up, inflation quickly will too.

“If this happens, Mark Carney’s 2% target will be out of reach,” he says. “If however, wages remain mute up to 2.5-3%, Carney will hit his inflation target in two years’ time.

“That’s the key judgement the monetary policy committee are having to make right now. In my opinion, I suspect that the law of supply and demand will reassert itself but there’s scant sign of it at the moment.”

Inflation-linked assets

Hooker argues that bonds and gilts are the safest investment to protect against inflation. “As I look around the world, the outlook for inflation is uncertain,” he adds. “I don’t understand how quantitative easing is going to work, how low interest rates are going to work and I don’t understand how wages are not responding to the low levels of unemployment.

“But, what I do know is that there is only one asset class in the financial markets that will protect you from an unexpected inflation shock and that’s index-linked gilts or inflation-linked bonds.”

A keen advocate for inflation-linked bonds, he believes that holding these securities until maturity will allow investors to be able to gain in “real terms”.

He adds: “This view is because of the uncertainties regarding wage inflation, the unconventional monetary policy and what the average investor holds (17% in fixed income, 4% in inflation-linked bonds). I would argue that investors should think about holding more inflation-linked bonds within their portfolio as they are underrepresented.”

Expensive and low-yielding

However, inflation-linked bonds are not the asset for everyone, according to Jason Broomer, head of investment at Square Mile.

Referring to inflation as being “absolutely lethal to bonds”, he says: “People assume that inflation-linked bonds will protect them if inflation ticks up, but I have reservations about that assumption.

“I think UK inflation-linked bonds are very expensively priced and yields are really low. They could be vulnerable if we get a bond market correction caused by inflation pressures and perhaps will not behave in the way you would assume.

“Valuations of index linkers are so high at present they can sell off heavily even if an inflation scare begins.”

 So what is a safer investment?

Broomer adds that a traditional asset which is seen as an inflation hedge is gold, although he wouldn’t describe it as the best one.

“In the period of rising inflation, I think the best one will be the one closely tied to short-term interest rates which are likely to climb as inflation takes over.

“Over the long term, a real asset such as equities or property should protect you, but over the period of rising inflation, the uncertainty it presents to economies means that the price of equities tend to get clobbered.

“Particularly, at the moment when market valuations are quite high, if we do get an inflation spike suddenly, I’m not so sure that equities will protect your money that well in the short term.”

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