Hedging against inflation, is it possible?

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Current inflation has not escaped anyone’s notice, and among students there is great concern about its height. The first estimate from CBS indicates that inflation in the Netherlands in October was 16.8% based on preliminary figures. This is a slight decrease from September’s inflation rate of 17.1%. Nevertheless, this is an exorbitantly high rate, and assets are going up in smoke.

Current inflation 

The average student, of course, does not have a large amount of assets. The price increases will therefore most likely lead to a higher debt with DUO for a number of students, and in addition, the interest rate on the debt has risen to 0.46%. Inflation is driven by factors beyond an individual’s control. Still, there may be other ways to combat inflation. Some popular ways to preserve purchasing power are examined in this article. Perhaps there are some ways to allay concerns. 

Gold

Holding gold is seen by many investors as a good hedge against inflation. For example, Peter Schiff said “gold will shine in an inflationary environment.” To see if gold is indeed a good way to preserve value, we will look at the results of a few scholarly articles. Ghosh et al. (2004) examined whether gold is an effective inflation hedge. Through an empirical analysis, the article reveals that over a long time horizon gold can indeed act as a hedge against inflation. However, the nominal price of gold is dominated by short-term influences. So over a short time horizon, it can be very detrimental to invest in gold. For example, an investor who would have invested in gold in January in 1982 and held it through December 1999 would have lost 59% in real value. Beckmann and Czudaj (2013) reach the same conclusion in their study that gold can partially hedge inflation in the long run. In particular, consumer prices can be hedged in the long run by investing in gold. In the short term, however, it is not possible for an investor to hedge a portfolio against inflation by investing in gold. The characteristics of an economy during a given period mainly determine how gold responds to inflation. However, the scientific research by Hoang et al. (2016) indicates that gold is not a hedge against inflation in the long run. In the United Kingdom, the United States and India, gold does form a hedge against inflation in the short term. The contradictory result of this article compared to the other articles can be explained by the introduction of nonlinearity. This article proves that the relationship between gold and inflation is not a linear one in a number of countries. For example, a nonlinear relationship is visible in more developed countries, and a linear relationship is visible in developing countries. Thus, gold might be better used with the goal of building a more diversified portfolio. Based on the results of academic articles, I would advise against using gold as a hedge against inflation. The results are contradictory. Moreover,  some articles do argue that gold can be used as an inflation hedge in the long run, but this requires a very long time horizon. 

Real Estate

Another way often mentioned to combat inflation is to invest in real estate. An accessible way to invest in this is through a Real Estate Investment Trust (REIT). This is a company that owns real estate and generates income on it. Thus, by purchasing a REIT, it is possible to invest in real estate indirectly. Rubens et al. (1989) examined how a number of portfolios consisting of, among other things, different real estate types fared with respect to inflation. Each portfolio formed at least a partial hedge against inflation when it came to expected inflation. When inflation was unexpected, all portfolios formed no hedge against inflation. Thus, the type of inflation largely determines whether real estate can be used against inflation. Current inflation is high, and it is expected to remain high in the short term. Currently, therefore, real estate could be a way to hedge against inflation provided the expected inflation is similar to the eventual actual inflation. The portfolio consisting of financial assets and residential real estate from the article has the highest Sharpe ratio. Thus, with current expected inflation, it would be most attractive to invest in a REIT that focuses on residential real estate. Another scholarly article by Park et al. (1989) focuses specifically on hedging inflation through REITs. Equities typically perform poorly during times of high inflation. Although REITs have real estate income as an underlying asset, it could be that, like stocks, they still do poorly when there is high inflation. The study finds that REITs actually perform similarly to stocks, and thus are not a good inflation hedge. However, it does show that when distinguishing between expected and unexpected inflation, REITs can be partially used as an inflation hedge when inflation is expected. Thus, this is partially consistent with the findings of Rubens et al.

Inflation-related bonds

Another way commonly mentioned to hedge against inflation is to invest in inflation-related bonds. Here the coupons and principal are linked to current inflation. This therefore directly protects the bond against inflation. However, an inflation-linked bond does not protect against inflation in the short term. The price of an inflation-linked bond goes down when yields go up, just like a regular bond. When the consumer price index is compared with the yield of inflation-linked bonds over 1-year periods, it is apparent that there is little correlation between the metrics. So in the long run, an inflation-related bond protects against inflation, but not in the short run. Another important aspect of these bonds is that expected inflation is priced into the price of the bond. So an inflation-linked bond protects against unexpected inflation. Therefore, if actual inflation is lower than expected inflation, a negative result is achieved on an inflation-linked bond.

So is it possible to hedge against inflation?

It is possible to hedge against inflation, but obviously this is not without risk. When investing in REITs or inflation-linked bonds as an inflation hedge, the effectiveness depends in particular on actual inflation relative to expected inflation. When high inflation is expected, and it materializes, inflation can be countered by investing in REITs. When inflation is higher than expected, it is advantageous to own inflation-linked bonds. The effect of investing in gold as an inflation hedge is questionable. Thus, inflation worries cannot be directly alleviated since the effectiveness of hedging against inflation depends heavily on expected and actual inflation.