Commentary, April 8, 2022
Hedging investment portfolios against the risk of a real loss of value has only played a minor role over the last two decades. In fact, until not too long ago, deflation, i.e. retreating consumer price indices, seemed the more imminent danger in this context. The more wrongfooted investors might have been in the face of the currently broad based price rises both for producers and consumers alike. In fact, the dynamic and heftiness might have even surprised professional investors, also from a long argued “temporariness” point of view of this relatively recent phenomenon. Yet even the last doubters of the seriousness of this topic might have surrendered in the face of consumer price rises of 7.5% p.a. in the Eurozone and 7.9% p.a. in the United States in March 2022. Besides, too many facts – record high natural resources and commodity prices, production disruptions owing to the Ukraine/Russia conflict and resurgent Covid-19 supply disruptions to name but the most important – hint at a very lasting inflationary spiral, probably feeding into almost all parts of daily commercial and private life. The question now is how to best protect nominal values from these negative effects?
Unfortunately, there is not the one asset class that can protect portfolio values from a lasting loss in purchasing power. However, as so often, a broad based and well-balanced approach might mitigate it partly, at least. For pure bond investors, inflation linked government bonds could be a prime choice to hedge against inflation. Though the bond principal and interest payments are protected against price rises, these instruments also carry some interest rate risks with them. This results from the simple fact that practically all future cash flow dependent assets experience reduced current values as a consequence of rising interest rates as long as other things stay the same. Hence there is a risk of loss of value due to negative discount effects during periods of rising interest rates. To mitigate this risk and still be able to reap the benefits from inflation protection, short duration approaches should be preferred.
As a close proxy to inflation linked bonds, infrastructure equity investments can also be used as a relatively stable, reliable and wealth preserving investment. Global listed infrastructure, an easily accessible investment for individual investors, has delivered returns exceeding average inflation rates over the long-term in many cases. This comes as most infrastructure assets are explicitly linked to inflation through regulation, concession agreements or contracts. Those without an explicit link often have the pricing power to deliver a similar (or better) outcome reflecting their strong strategic position. Last, but not least, infrastructure assets often benefit from some kind of direct or indirect public protection against economic distress or even default due to their strategic character. Risks from investing into equity should however not be completely neglected, although this asset class can be judged as low-beta, defensive and predominantly solid from a credit risk perspective.
To proceed further within the equity sphere, investments into listed real estate may be another valid inflation protection asset. This comes as commercial and residential rents often include inflation protection clauses. Also, real estate is being judged as an attractive safe-haven asset due to its physical character. Yet risks from fluctuations in equity (markets) can be substantial and real estate might also suffer in value during economic downward periods. The latter often is a result of a contraction in credit growth owing to peak key interest rates and/or rising vacancy rates of commercial properties.
Consumer staples equity, coupled with high dividend qualities, may be another effective investment for the purpose of real wealth preservation. Especially in periods of rising energy and soft commodity prices, food processing and distributing companies have a high likelihood to be able to pass on rising input costs. Especially those companies that exhibit substantial price setting power should cash on mounting nominal values. Typical stock valuation measures (price-earnings ratios, dividend yield and margin ratios) as well as intrinsic value measures might be useful to assess the relative attractiveness of these stocks. Cost intensity and risks to supply chains should be considered too. As these stocks range among the most defensive ones, they should suffer substantially less downside volatility during periods of falling stock indices and should be the last to fall during an economic downturn. In this context, equity investments into timberland, farmland and agricultural producers pose an attractive shield for real value focussed investors. They are, however, difficult to implement from a timing perspective, as their value might already have risen substantially before broader price indices can capture commodity driven inflation.
In general, portfolios can of course best be hedged against commodity price induced inflation by investing into the underlying source of broader price pressures itself, i.e. the respective commodity. This often involves the use of derivatives or derivative based solutions. Disadvantages such as performance divergence between the underlying value and the derivative value may cost performance but by investing directly dilutionary effects from a more indirect exposure via equity investments for example can be avoided. In this respect gold is often hailed as the one inflation hedging commodity investment. While gold seems to exhibit considerable wealth preserving characteristics as a relatively liquid reserve currency, its systematic hedging qualities against supply side induced currency debasement coupled with rising real interest rates seem less straight forward. Nevertheless, from an inflation protection portfolio perspective it still looks like a “must have”.
From an implementation perspective, all-in-one mutual fund investment solutions might be most convenient for individual investors. Higher management fees come in return for much less rebalancing efforts on a portfolio level in comparison to single asset class investments. To avoid single fund misallocation risks, diversified investments over 3-4 mutual funds with inflation protecting characteristics as described above could be the most convenient solution. For those investors preferring 100% control over their target portfolio allocation, clean, asset class specific investments, should work best. Exchange traded funds, exchange traded commodities and derivatives will rank high among the preferred investment solutions. However, constant portfolio surveillance and dynamic portfolio rebalancing should be considered for this approach.
Manuel Schuster, CEO&CIO