Hedging Inflation: Which Investments Work?

By now, investors have become well aware of stubbornly-high inflation that has been hurting their portfolios, as consumer prices rose at the fastest rate in 40 years. While investors can park their cash in inflation-resistant assets, it’s important that they carefully evaluate their options to ensure optimal performance.

The Federal Reserve has aggressively hiked interest rates over the year to fight inflation, raising Federal Funds from near zero at the start of the year to 3.08% at the end of September 2022.

In September, Chair of the Federal Open Market Committee (FOMC), Jerome Powell, announced a 75 basis-point (bps) interest rate increase, with potentially more lethal hikes lined up for the remainder of the year, leading into 2023. However, inflation isn’t the only economic factor that has been putting pressure on consumers and investors.

More than two years into the pandemic, supply-chain disruptions continue to leave manufacturers and suppliers understocked, with many struggling to meet supply with demand. The tight labor market conditions have also been a setback for the recovering economy, while geopolitical tension between Russia and Ukraine has only escalated since the invasion started in February.

On the back of this, Wall Street has been signaling the possibility of a recession looming on the horizon, as economic conditions have been eroding faster than some initially predicted. In a recent interview with CNBC, hedge fund manager Paul Tudor Jones mentioned that he believes the U.S. economy is nearing or has already entered a possible recession.

With so much to consider, investors will be continuously looking to diversify their portfolios in an effort to hedge inflation and curb the ongoing economic challenges.

5 Investments to Protect Portfolios Against Inflation

Investors might have already considered alternative strategies to help combat the higher inflation that’s eating into their returns. On top of this, investors will need to think of the long-term challenges inflation can impose on their portfolios if they don’t act swiftly.

With ongoing market volatility that could potentially trigger a recession, here are some of the best investments for investors looking to protect their portfolios against inflation.

1. Commodities

Investors often find a soft landing with commodities, including oil, natural gas, precious metals such as gold or silver, or corn and wheat. Generally speaking, commodities act as a natural hedge against inflation as they tend to drive inflation in consumer goods.

Aside from gold, oil, and other commodities, investors can also look to purchase commodity stocks, which include valuable companies such as Vale S.A. (NYSE: VALE), BHP Group Limited (NYSE: BHP), SunCoke Energy, Inc. (NYSE: SXC) and Cleveland-Cliffs Inc. (NYSE: CLF), among many others.

Investors can also look at Exchange Traded Funds (ETFs) or mutual funds. These two options have been more common among novice and small-scale investors who do not carry a large enough portfolio to experience massive inflationary changes. Investors generally don’t keep commodities for too long and start selling off most of their commodities once a recession and inflation begin to cool down.

2. Floating-Rate Bonds

Generally, floating-rate bonds or floating-rate funds contain financial instruments such as bonds, bank loans, or floating interest. These types of instruments attract yield-hungry investors that are looking for a simple yet financially viable solution to mitigate the effect of inflation on their portfolios.

Typically, floating-rate funds will invest between 70%-80% of their investment holdings in floating bank rates, which would see an uptick in payouts as interest rates increase due to higher inflation. The other 20%-30% is invested in cash or investment-grade bonds.

Not only do floating-rate bonds offer investors inflation protection, but there is also a higher certainty of diversification, lowering the exposed risks and volatility of an investor’s portfolio.

3. Treasury Inflation-Protected Securities (TIPS)

Considered a safer and more traditional investment choice during times of higher inflation, TIPS are government bonds pegged to inflation. Investors that expect inflation to fluctuate relatively quickly and more frequently tend to invest more cash in TIPS. These bonds move with effective interest rates.

Perhaps one of the main, if not only, reasons why investors tend to purchase TIPS is because they are backed by the federal government. With this in mind, investors tend to feel that treasury securities are a safer option during inflationary conditions.

Something investors need to keep in mind when investing in TIPS is that when interest rates subside or don’t increase, TIPS tend to become less valuable. The same goes for when inflation is lower-than-expected. It might be better to then choose more conventional bond options.

4. Infrastructure

Another option would be to purchase property or infrastructure, as these purchases have a lower correlation to bonds and equities. This is especially true in highly-volatile market conditions and deteriorating macroeconomic conditions.

Investing in infrastructure is not a common tactic many investors consider during market downturns, yet cash flow for these projects, such as roads, bridges, buildings, or tolls, are directly linked to the real economy, which tends to receive a major boost from the federal government during market downturns.

Investors that do not have direct access to infrastructure investment opportunities can look at other options such as iShares U.S. Infrastructure (IFRA) or Global X U.S. Infrastructure Development ETF (PAVE), which have been outpacing the S&P 500 (SPX) this year.

5. Dividend Stocks

Lastly, we get to equities, which are, in general, considered to be a safe bet against inflation. More so, equities tend to be easier to purchase as well, with more purchase pools available from which investors can choose.

Although equities tend to deliver against rising inflation, especially dividend equities, which attract retail investors, these types of investments create broad portfolio diversification. It’s also a bit easier for investors to sell their equities once the market has turned, or if share prices are falling, it makes equities a lot easier to manage.

Final Thoughts

Inflation looks to remain elevated for much of the year, and going into 2023, we might see the Federal Reserve continue its aggressive monetary tightening to control soaring consumer prices. For investors, this is not only a good time to revisit their strategies, but it also presents the opportunity to diversify their portfolios and select investment choices that can help hedge against inflation.

Although it’s not to say that these investments will completely help to mitigate the impact inflation has on portfolio returns, they often help lower the effects of high market volatility and long-term risks.

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