In 2021, the United States recorded the highest inflation rate in more than 30 years. One of the main reasons for this inflation is the quantitative easing programs approved by the Federal Reserve to buy bonds to counter the economic recession caused by the Corona pandemic, which led to an increase in the money supply. So what is inflation?
Inflation is the decrease in the purchasing power of a currency over time, meaning that $100 today will not buy you the same amount of products or services after a period of time, and thus you will have to pay a higher amount for the same products and services. Inflation reflects the rate of rise in the prices of products and services in general. The inflation rate is expressed as a percentage of the annual rate of change in the prices of a group of products, and one of the most famous indicators of inflation is the Consumer Price Index (CPI).
What are the causes of inflation?
There are 3 main causes of inflation:
- Demand-pull: This type of inflation occurs when the money supply increases as it leads to an increase in the demand for products and services in general. An increase in the demand for products and services leads to an increase in prices.
- Cost-push: When inflation occurs as a result of a rise in production costs.
- Built-in: When the cause of inflation is adjusting to expectations of future inflation, employees and workers demand a raise in their salaries and wages.
What are the best assets to hedge against inflation?
By the end of November 2021, the inflation rate in America reached 6.2%, the highest since 1982. With high inflation rates in mind, investors are looking for the best assets to hedge against inflation to protect their money from depreciating purchasing value.
In this table we review the lowest, maximum and average annual real returns for various asset types between 2012-2020.
| Instrument Type | Lowest Annual Return (%) | Average Annual Return (%) | Maximum Annual Return (%) |
| Global Stocks | 11.6 | 15.4 | 24.5 |
| Stocks of large US companies | -6.3 | 14.3 | 30.9 |
| Infrastructure Sector | 8.8 | 12.3 | 23.8 |
| Real estate funds | -7.3 | 7.2 | 26.4 |
| Gold. | -28.8 | 6 | 23.2 |
| Treasury Inflation Protected Securities (TIPS) | -10.1 | 2.6 | 9.6 |
| foreign bonds | -9.6 | 1.8 | 14.1 |
| floating bond | -0.4 | 0.0 | 2.2 |
| Commodity | -33.9 | -2.7 | 15.3 |
| Energy Sector | -38.0 | -11.5 | 36.7 |
Global stocks have recorded the highest average annual real returns over the past years, trailed by large US company stocks and then infrastructure stocks. Gold managed to achieve a return that exceeded the inflation rate almost 50% of the time, but despite that, gold recorded a return of -30% in 2013 less than the inflation rate in the worst year for gold. Among the various asset types mentioned, only commodity and energy sectors had negative average real returns during the period. However, the energy sector also recorded the highest annual maximum return during the period.
The cross-sectional data may be limited in scope due to the short period of time tested, and also for another reason that the inflation rate in America over the past few years has been less than the 2% per year which is the target rate by the Federal Reserve. Of course, assets may respond quite differently during periods of high inflation. For example, stocks recorded the best real return when the annual inflation rate was between 2%-3%. But returns may be more volatile during periods of high inflation, because inflation may raise costs and reduce profits.
During the 1988-1991 period when the average annual inflation rate was 4.6%, commodities recorded a compound annual return of more than 20%. The performance of gold fluctuated during periods of high inflation, despite that, gold recorded a compound annual return of 35% for the period between 1973-1979.
What is the best way to hedge against inflation? There is no absolute answer or one asset type that protects against inflation absolutely, as all assets have performed differently during different inflation periods. Instead, the investor should focus on diversifying his portfolio between different types of assets such as stocks, real estate, commodities, gold or, more recently, cryptocurrencies. This may help to hedge against inflation and help the investor maintain the purchasing power of money.
References
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Past performance is no guarantee of future results.
Your investment can fluctuate, so you may get back less than you invested. Consider each product’s risk(s) before investing.
Baraka is not a financial adviser and therefore does not provide financial advice. Our content is informational only.
