Thoughts on commonly used inflation hedges

Thoughts on commonly used inflation hedges

Just because we do not believe that runaway inflation is on the horizon, it does not
mean that we do not support a certain portion of investors’ portfolios being committed
to asset classes that historically have done well during inflationary periods. Before we
look at the more traditional inflation hedges, it is important to remember a couple of
facts. First, the return of an asset class or investment strategy is rarely driven by only
one thing, such as inflation. Second, investors make investments (other than pure
income investments) based on what they expect to happen in the future. We buy stocks
today because we expect them to be worth more in the future. Ditto for value-added
real estate, commodities and many other asset types. The same holds true for inflation
protection asset classes. If everybody believes that inflation is around the corner, the
investment community will buy what they perceive to be inflation protection assets today
in anticipation of what is to come – thereby driving the prices higher in advance of the
actual inflation.

Stated differently, traditional inflation hedges generally move higher during periods
when inflation is anticipated in the future. Asset appreciation may not persist once
inflation actually materializes. On the other hand, inflation assets generally appreciate in
harmony with inflation when inflation occurs unexpectedly.

There are two take-aways from this. First, the portion of investors’ portfolios dedicated
to inflation protection should be diversified across multiple asset classes or strategies.
This will help mitigate the risk of an asset class’s specific problem negating the
investment’s inflation fighting characteristics. Second, investors may find it difficult to
time the addition of inflation protection strategies. A better plan is to accept the fact that
some periodic inflation is an economic reality and having inflation hedging assets in the
portfolio when inflation occurs makes more sense. In addition, just because an asset
type tends to work well during periods of inflation, it does not mean that the asset type
will not work well during periods of low inflation.