Some asset classes better than others as an inflation hedge
When preparing your financial plan and setting target returns, make sure you discuss the effects of inflation with your advisor.
Currently, inflation is at levels not seen in decades. In Canada, the Total Consumer Price Index for September climbed to an alarming 6.9% annual rate. In response, the Bank of Canada has hiked rates six times this year for a total increase of three percentage points since March, the most recent being October’s half percentage point increase, bringing the Bank’s policy rate to 3.75%. And neither inflation nor the Bank’s attempts to bring it back down are done yet. So facing the twin fire-breathing dragons of inflation and rising rates, where can investors put their money with at least some defence against erosion of value? Here are some suggestions.
Real Return Bonds
Real Return Bonds (RRBs) issued by the Government of Canada provide a hedge against inflation by raising the principal semi-annually to offset the inflation fate. Interest payments are based on this inflation adjusted principal, so they too will increase as inflation increases. At maturity, the entire inflation-adjusted principal amount is paid to the bondholder, thus preserving the investor’s purchasing power.
These bonds work best in times of rising inflation, because the same process used to determine the bond’s principal and interest payments works in reverse, shrinking as inflation declines. RBBs typically have longer maturities, and therefore have more price volatility. To be most effective, investors should be prepared to hold RRBs in their portfolio for the long term.
Because there are only eight issues of RRBs outstanding in Canada, liquidity is a problem. So it makes most sense for investors interested in this option to look at mutual funds or exchange-traded funds for this type of exposure. Search a comprehensive database like The Fund Library in the Canadian Inflation Protected Fixed Income category.
Granted, the stock market is not usually the first place that comes to mind when searching for some inflation protection. After all, rising inflation comes with rising interest rates, which are poison for stock markets as the rising cost of borrowing dampens earnings into the future.
But some businesses thrive during inflationary periods. These tend to be businesses in the consumer products sectors. They manufacture products that people need and will keep buying, even at higher prices. For example, the S&P/TSX Capped Consumer Staples Index is up 3.9% year to date, and includes such companies as Alimentation Couche-Tard, Loblaw, Premium Brand Holdings, and Maple Leaf Foods.
Another example is the S&P/TSX Capped Energy Index, which has defied gravity through 2022 and is ahead 60.2% year to date. Bear in mind that this surprising outperformance is mostly a result of the global energy supply crunch brought on by government-mandated cutbacks or halts in exploration, development, and pipelines in both the U.S. and Canada, OPEC production caps, and sanctions on Russian exports as a result of its invasion of Ukraine. But the energy sector has typically always done well historically in times of inflation.
In addition to energy and consumer staples, individual stocks and funds in the healthcare, technology, and building materials sectors also hold up well in times of inflation.
Investors might also consider a balanced portfolio of short-term bonds, which are less sensitive to rapid rate hikes and allow for faster turnover into higher-yielding issues, and dividend-paying value stocks, which provide steady income and the potential for capital gains.
Gold and other commodities
Gold has often been used as a crisis hedge and a hedge against inflation because it tends to holds its value. But the price of gold is also driven by fundamental factors of supply and demand, including increasing or declining holdings of central banks, jewellery, and industrial usage. This gives rise to price volatility. And combined with the fact that physical gold produces no income, it is less than ideal as a perfect inflation hedge.
Other commodities, like grains, fertilizer, base metals, and natural gas to take a very few examples, can hold their value during inflationary periods, but can also be very volatile as prices depend exclusively on global supply-and-demand factors. Funds that hold these and shares of resource companies that produce them are subject to the same risk of price volatility, and thus may not make the very best inflation protection.
Ultimately there is no sure-fire hedge against the erosion of your investment dollar by climbing inflation rates. Real Return Bonds come close, but are really meant for the long term, to guarantee the purchasing power of your principal along with a small income stream along the way. Carefully selected stocks from sectors with the most potential to benefit from inflation could be your best bet, but this requires a high degree of selectivity.
When you update your plan, be sure to readjust the inflation rate you use to be consistent with the Bank of Canada’s target. And you should always target your desired investment return to be greater than the rate of inflation. As always, consult a professional financial advisor before investing or making changes to your portfolio.