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Most of us are aware of how high inflation has taken its toll over the past 18 months and the majority of us are feeling it in our hip-pockets. After staying low for years, inflation—as measured by the consumer price index —peaked at 7.8% in December 2022 which is the highest annual rise since 1990. Some 13 interest rate rises later, and inflation is heading in the right direction, albeit slower than most of us would like. Annual inflation came in at 3.5% for the year to March 2024, while the most recent inflation figure for the month of April was slightly higher at 3.6%.
Inflation has been 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 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 yet raise rates one more time in 2024 before cutting.
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.
In any case, the cost of living is not the only thing impacted by inflation—our investments are, too.
Related: Mortgage Calculator: Calculate Your Mortgage Repayments
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 over the past two year—remember even the RBA was surprised— some of these assets are now quite expensive.
“A well-constructed portfolio should always cater to a range of potential scenarios. That also includes some assets that prefer an environment where inflation is high,” says James Foot, head of research at Morningstar Australasia.
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.
“Australian inflation-linked bonds are currently trading on a breakeven rate of about 2.5% for the next 10 years,” says Foot.
“That means if inflation exceeds this level over the next decade, then you will be better off holding 10-year inflation-linked bonds compared to the nominal equivalent. If inflation turns out lower, then nominal bonds will be superior. In the US, the equivalent 10-year breakeven rate is slightly lower at around 2.3%.”
Traditional bonds are also great in recessionary environments.
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.
“The prevailing growth and rate backdrop has been affecting assets in different ways,” says Foot.
“Energy, commodities, inflation-linked bonds, and floating rate notes each prefer an environment where inflation is high and rising. Inflation-linked bonds have a linkage to inflation but there is also a duration element—so they prefer high inflation and falling growth. Energy is not averse to inflation but differs to inflation-linked bonds in that energy prefers stronger economic growth.”
Floating rate notes are a form of fixed income investment, where the principal is repaid at maturity, and the interest rate is tied to a market interest rate.
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.
“Many of the valuation opportunities right now are presenting in those assets that would prefer a fall in inflation and rates. Value often resides where the stress sits. For example, Global REITs offer sound valuations right now and have been left behind compared to broad markets,” says Foot.
REITs that are linked to inflation are also considered traditional inflation hedges. But they can also be hugely impacted by interest rate increases.
“REITs have a linkage to inflation, but they carry leverage which makes them susceptible to higher interest rates,” Foot explains.
“US REITs legally need to pay out a large proportion of their earnings. They often use debt to grow. So, while REITS may hold assets with rental escalation clauses, this dynamic is being more than offset by their debt profile, which has seen REITs exhibit high sensitivity to rates.”
US Small Caps
Small market capitalisation, otherwise known as ‘small-cap’ is when a company’s share price multiplied by the outstanding number of shares falls between $US300 million and $US2 billion. Relatively speaking, these companies tend to be young.
US small caps are currently showing “reasonable value”, says Foot.
“Small cap equities are also interesting and would benefit from a further fall in inflation and rates–they often have lower margins compared to large caps,” he says.
“That means rising debt costs disproportionately impact them from a fundamental earnings perspective. US small caps have underperformed in this environment, where debt costs have risen.”
Diversification of Defensive Assets
Along with choosing the right types of investment, enhancing portfolio resilience is something Foot believes is key. This can be achieved by diversifying into assets that are more defensive.
“That’s where government bonds can play a role,” says Foot.
“Government bonds would prefer falling inflation but can offer somewhat of a hedge against an economic slowdown. They can be used in combination with assets that are more economically sensitive.”
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 was in December 2022 at 7.8%. As of May, 2024, it has eased to 3.5%.
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 a combination of both.