Traditional Hedges Might Soothe Inflation’s Sting

Question:

What’s the best way for me to take some of the bite out of inflation? Should I put some money in Treasury Inflation Protected Securities (TIPS)? Buy gold? Or get into a Real Estate Investment Trust (REIT)?

Answer: 

Yes, those are all traditional inflation hedges. Will they help take the edge off in this market? Maybe.

TIPS are U.S. government bonds that index their face value with inflation. If you buy TIPS today at $100, and 5% inflation occurs, a year later your bond will have a face value of $105 and all the dividends will be 5% higher as well. This sounds like a silver bullet, but few things are that simple. The bonds are traded on the open market and are priced to include expected inflation. Typically, they trade at prices that assume inflation will be higher than most forecasts. In other words, if experts believe inflation will be 5% next year, the TIPS might price in 7% inflation, meaning investors would need inflation to be 7% just to get some nominal return. So, while TIPS are really good insurance against unexpected inflation, they do little good when inflation behaves as expected.

As a hard currency, gold has a reputation as a good inflation hedge. That rep is based a little bit on history, a little bit on theory and a little bit on fear. The last time inflation was a significant problem in the United States (1970s and early 1980s), people who bought gold were some of the only investors who had success. The theory is that gold stores grow very slowly, while governments can print fiat currencies at will. Therefore, the price of gold should inflate at the same rate as the currency. As for the fear factor, some investors worry that central governments during economic downturns will just print money to absolve national debts, causing massive inflation, and that precious metals will better protect purchasing power. The drawback is that owning gold has a cost. As interest rates increase to fight inflation, that cost limits gold’s effectiveness.

Real estate is the most traditional inflation hedge and with good reason. It takes the hard-asset theory of gold and adds a productive component by earning rents, which typically increase with inflation (rent is a major component in calculating inflation). Unfortunately, it suffers a similar problem to both gold and TIPS. Some amount of inflation is incorporated into the price, and as a security that produces future cash flows, higher interest rates reduce a REITs value.

So, which of these hedges should you use to protect against inflation? Some or all of them can work, depending on how worried you are about current inflation versus inflation spiraling higher than anyone expects.

Discuss it with your AMG advisor today.