# Hedging inflation may never have been trickier

## Effective hedging depends on what’s causing prices to rise

With the US Consumer Price Index rising 8.5% for the year to the end of March, its highest since 1981, the question of how to hedge inflation has become the topic du jour. It may prove a less than straightforward task.

Inflation comes in different forms, and investment managers warn that hedges that work in one case might work less well in another. For instance, gold can be a good hedge against monetary inflation, while real estate and commodities provide better protection when supply-demand imbalances are at play. The challenge is made tougher because today’s rising prices reflect multiple underlying forces working at once.

Shortened supply, ballooning demand and monetary policy are at play. The balance of influence, though – and so the optimal form of protection – is harder to pin down.

“It’s been a long time since we’ve had anything other than the usual demand-driven inflation,” says Ed Peters, managing partner at First Quadrant, a quant investing firm. Inflation today is more complex than at any time since the aftermath of World War II, he reckons.

Peters likens inflation hedging to the treatment of heart disease, an ailment with multiple possible causes. Treated with the wrong cause in mind, the problem just gets worse, he says.

### Hey big spenders

Some things are clearer than others. Rising demand and constrained supply are both in evidence.

Lockdown-induced thrift has given way to a consumer splurge. In March 2020, US savers were stashing money at four times the previous rate. By early this year, the share of income those savers retained after taxes and spending had fallen to its lowest since 2013. Personal spending rocketed 6.1% higher in January – the biggest rise in forty years.

Production lines that slowed or halted in the pandemic, meanwhile, are struggling to recover speed. An index of global supply chain disruption calculated by the Federal Reserve Bank of New York remains near all-time highs, despite a lessening of stress in recent months.

Elsewhere, the picture is less clear cut. Policy-makers pumped the financial system with liquidity, including US$700 billion in quantitative easing (QE) and the US$2.3 trillion Coronavirus Aid, Relief and Economy Security Act. US money supply hit a record high in December 2021, though it has fallen this year, as the Federal Reserve has started to wind down QE and initiate rate hikes. Yet the velocity of money – another key influence on inflation – is at the lowest level since records began in 1959.

Nor are these factors stable. UBS Global Wealth Management said in an April note there were signs that pandemic-related price distortions were starting to fade, with price rises in some goods moderating or even declining. Data on money supply and GDP comes with a three-month lag, so signs of monetary inflation may not be fully in evidence yet.

### What’s the source?

That leaves investors with much to ponder.

Hedges that work well for demand-driven inflation may fare less well if supply bottlenecks are the dominant factor. Standard ways of protecting against monetary inflation could prove weak in the face of inflation from other sources.

Real estate investment trusts are a good hedge against demand inflation, but poor if inflation comes from easy money, Peters says. Gold can hedge against money-supply gluts but not so well versus overheating consumption. Agricultural commodities do well when goods are stuck in the warehouse or factories are shut down, but may stumble at other times.

History bears this out. Take equities, often seen as less sensitive to inflation because companies can hike prices in line with rising costs. Stocks did well during the monetary inflation of the late 1970s but fell during the 1980–1982 recession.

Commodities did well during the 1979–1982 monetary inflation period, but less so in the 1969–1973 monetary inflation episode after the US abandoned the convertibility of US dollars to gold.

What, then, should investors do? First Quadrant’s analysis shows that industrial commodities, alongside stocks in producers of industrial and precious metals, energy resources and other basic materials, have been the most reliable hedges in both a supply- and demand-driven inflationary environment – the type of inflation that markets are experiencing now as Peters sees it.

But the uncertainty, particularly relating to central bank policy and how it affects markets from here, means investors should prepare for all scenarios, he says. That demands a portfolio of hedges. A straightforward bet on, say, gold or commodities to provide protection may not be enough.

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