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Most of us are aware of how high inflation has risen over the past 12 months and the majority of us are feeling it in our back pockets (kudos to you, if you aren’t). After staying low for years, inflation—as measured by the consumer price index —was 7.8% annually in the December quarter which is the highest annual rise since 1990.
Inflation is high for two main reasons. During Covid, the supply of many goods was constrained as production decreased or stopped altogether. When there are fewer goods but the same amount or more people demanding them, prices will rise. There is also the demand side. When interest rates were so low, people had more buying power to spend on goods during the pandemic. So supply was lower but demand was much higher—resulting in the prices we have now.
On the demand side, one of the tools available to the Reserve Bank to deal with inflation is monetary policy or adjusting interest rates. If you have a mortgage, higher interest rates increase your repayments and reduce the money you have to spend. If you are spending less, i.e. demanding less, then prices and inflation are supposed to go down. That is the thinking of the RBA at least, which may continue to raise interest rates until they are happy inflation is under control.
But if interest rates rise too high, and too many people default on their mortgages, we also face the possibility of a recession, so it’s a very fine tightrope policy makers need to walk.
Related: Mortgage Calculator: Calculate Your Mortgage Repayments
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How to Fight Inflation through Investments
Some kinds of investments are considered inflation hedges, which means that regardless of what happens to inflation they will still maintain their value. However, because inflation snuck up on us all so quickly—remember even the RBA was surprised— some of these assets are now quite expensive.
“It’s an interesting and evolving topic in the sense that the best time to set your portfolio up with inflation hedges is when nobody else wants them,” Morningstar Australasia head of institutional portfolio management and solutions, Jody Fitzgerald, says.
“Because that’s when you actually get assets at a good price.
“And because inflation has actually surprised the market by being persistently high … a lot of those traditional inflation hedges aren’t cheap anymore. And that needs to be taken into consideration rather than just blindly buying something knowing that it provides a hedge.”
Let’s take a look at some of your potential options.
Bonds
Inflation-linked bonds are a kind of fixed-income investment that is designed to protect investors from inflation. Principal and interest payments are linked to the CPI and rise if inflation rises.
According to Fitzgerald, inflation-linked bonds in Australia are currently quite expensive and not very attractively priced for the hedge they could offer investors.
“So the problem with any inflation hedge when the valuation isn’t cheap, you have a higher risk of a sell-off in that asset and it not providing the hedge you want,” Fitzgerald says.
This doesn’t mean they don’t have a place in a portfolio, but it probably wouldn’t be wise to shift all your investments in them today.
Traditionally nominal bonds have not been a great inflation hedge. But if we are heading for a period of disinflation—where inflation rises but at slower rates—Fitzgerald says that long nominal bonds may provide investors with good diversification.
Following the shakeout in the bond market last year due to the rapidly rising interest rates, bonds are now priced at some of the better levels they have been in some time. Traditional bonds are also great in recessionary environments.
“So it’s quite possible that as we move into a different type of inflationary environment, that long nominal bonds could actually start to do quite well. So thinking about having traditional nominal bonds as a diversifier for a portfolio is important,” Fitzgerald says.
Commodities
Commodities, which are indelibly associated with Australia’s GDP, come in two forms for investment purposes: hard and soft. Hard commodities, such as metals or energy, need to be drilled or mined, while soft commodities, such as wheat, are grown.
Commodities have long been considered a traditional inflation hedge because they are inputs into other goods. Cars need steel and other metals, for example. They are considered foundational and therefore their prices will generally rise ahead of prices for the end goods.
But, due to geopolitical crises like the war in Ukraine, the prices of many commodities are also currently very high and would offer an expensive inflation hedge with the risk, like Fitzgerald points out above, being the market could crash.
If investors want to grow their wealth with inflation currently at 7.8% they need to find investments that offer returns in excess of that and understand the higher risk that will ultimately come with those higher returns
REITs
Real Estate Investment Trusts (REITs) and other real estate investments that have underlying revenue streams have become popular among Australian investors. As the ASX points out, A-REITs are investment vehicles that offer “exposure to property assets such as office towers, shopping malls, industrial building” without a bricks-and-mortar purchase from the individual investor.
REITs that are linked to inflation are also considered traditional inflation hedges. But they can also be hugely impacted by interest rate increases.
“So you’ve got this real dual situation playing out where it’s not just the path of inflation, but it’s also the path of interest rates, which are arguably the two most critical variables in markets over at least the next year, possibly more,” Fitzgerald says.
“So getting that right balance between something that can withstand an inflationary environment, but also potentially a recession and much higher interest rates [is crucial].”
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Focus on Diversification
Fitzgerald’s key message in the current environment is not to avoid traditional inflation hedges completely, but to understand the risk of over-priced assets and to consider the potential for a variety of outlooks for all asset classes.
“Given the range of outcomes, what I would suggest that would be important to focus on is the range of inflation outcomes, the range of interest rate outcomes. And therefore the importance of proper diversification,” Fitzgerald says.
If investors want to grow their wealth with inflation currently at 7.8% they need to find investments that offer returns in excess of that and understand the higher risk that will ultimately come with those higher returns.
Note: When investing, it’s possible to lose some, and very occasionally all, of your money. Past performance is no prediction of future performance and this article is not intended as a recommendation of any particular asset class, investment strategy or product.
Frequently Asked Questions (FAQs)
What investments do well in inflation?
Traditionally, inflation-linked bonds, commodities and real estate can provide investors with some wealth protection during periods of inflation. However, these assets are currently very expensive and there are no guarantees.
What was inflation in 2020?
In December 2020 the rate of inflation was just 0.9%. This is in stark contrast to where it sits in February 2023 at 7.8%.
How does inflation happen?
Inflation occurs when there is too much demand for a good or not enough supply of a good or in some situations—like now—a combination of both.
