Rising inflation and how to hedge against it

In the first of a two-part series for Insights Hub, Andrea Gianellini, Senior Investment Analyst for VitalityInvest, explores the hot topic of inflation and how it is likely to impact investors.

According to the latest Consumer Price Index (CPI), UK inflation reached 9% in April. Not only is it at its highest level since March 1992, it is also well above the 2% inflation target set by the Bank of England (BoE).

If prices continue to rise but income levels remain the same, individuals are destined to see their money not going as far as it used to. Economists call this a decline in purchasing power. If not controlled, rising inflation can be costly for our economy: lower demand for goods and services increases the chance of economic slowdown and can potentially lead to a recession.

The current situation in Ukraine and the financial and trade sanctions imposed on Russia from around the world are causing significant disruptions of the supply chain of energy and food commodities in Europe and globally. We have already experienced the effects of these disruptions in the sharp increase of the price of oil, gas and wheat, which is likely to reflect soon on the prices of goods and services².

To mitigate the risk of inflation increasing further and faster, the BoE again recently raised its base rate for the third time in a row - to 1%, its highest level since 2009. Meanwhile, the US Federal Reserve raised its interest rates for the first time since 2018 in March and the BoE has been gradually reducing the quantitative easing measures launched to offset the economic impact of the pandemic. With the ongoing situation in Ukraine, the BoE will need to factor in the risk of a potential recession on the horizon when making any future moves.

How to hedge against inflation

Higher inflation means that savings and investments can be eroded - this implies that higher returns are needed to reach investors’ goals. However, the good news is that the risk of inflation can be hedged in a multi-asset portfolio. Here are four ways to hedge against it.

1. Inflation-linked bonds: this is a direct way to hedge against inflation risk.

Bonds typically provide a steady income stream (or return) in the form of coupon payments. With inflation-linked bonds, the coupons are directly related to inflation - the higher the level of inflation, the higher the coupon/return an investor receives.

2. Equity: In the long term, equity tends to provide a partial hedge against inflation.

Companies can raise the prices of their products when they see increased costs of labour and materials due to the inflationary environment. This translates into higher earnings, boosting margins and profitability, resulting in higher equity returns. Some sectors (e.g., value) tend to provide a better hedge against inflation.

3. Commodities: Often touted as the perfect hedge against inflation - but not always the case.

Commodities are the raw materials used to create the products consumers buy, and so when the price of goods and services rises, it may be the direct effect of an increase in the price of commodities.

4. Alternative instruments: Property, infrastructure, gold and other specific fixed income sectors.

These are more sophisticated tools which require careful consideration when added to a clients’ portfolio.

To find out what rising inflation will mean for Vitality funds, read Part Two.

Important information.

VitalityInvest is a trading name of Vitality Corporate Services Limited. Vitality Corporate Services Limited is authorised and regulated by the Financial Conduct Authority.

Past performance should not be taken as a guide to the future performance and there is no guarantee that an investment will make profits: losses may be made.

VitalityInvest makes every effort to ensure that the information provided in this commentary is accurate and complete but no guarantee or warranty is given. This commentary is for general information purposes only and is not to be relied upon in making an investment or any other decision. Nothing in this commentary constitutes investment, legal or any other advice. This commentary is for investment professionals only and any retail customers should speak to an authorised financial adviser before making any investment decision.

Sources:
1. https://www.bankofengland.co.uk/knowledgebank/will-inflation-in-the-uk-keep-rising
2. https://www.theguardian.com/business/live/2022/mar/02/oil-price-blasts-111-opec-meeting-sberbank-european-arm-closed-business-live