How to hedge against inflation

UK inflation, as measured by the Consumer Prices Index (CPI), rose to 2.3% in October according to the latest figures from the Office for National Statistics (ONS). This is an increase from 1.7% in September, and brings the official rate of UK inflation back above the Bank of England’s 2% target.

It is also higher than the 2.2% that experts had predicted ahead of the announcement, though not by much. According to Danni Hewson, head of financial analysis at AJ Bell, “no one will be surprised that the headline rate of inflation has ticked up again, however unwelcome it might be”.

Investors concerned about the latest UK inflation figures will want to know how to hedge against inflation in their portfolio.

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“Inflation erodes the purchasing power of money over time and impacts the value of investment returns,” Paul O’Neill, chief investment officer at wealth manager Bentley Reid tells MoneyWeek. “If my portfolio gains 8% in a year I may feel better off, but if prices have risen 10% I can afford less than I could at the start of the year.”

Increasing inflation also lowers the likelihood of UK interest rates falling in the near future.

“Market expectation of a further interest rate cut in December is now only 16%,” says Hewson.

Rising energy prices are viewed as the main driver behind the increase in inflation during October. “The increase in gas and electricity prices was the main factor behind the bigger than expected jump in headline CPI,” says Hewson.

How can I protect my wealth against inflation?

In general terms, the best defence against inflation is a well-diversified portfolio built with a long-term approach. This implies investing across a wide range of asset classes including commodities, infrastructure and global equities.

However, according to O’Neill “equities, real estate and gold are some of the best ways to hedge against inflation” based on historical trends.

Real estate

Real estate is typically viewed as a means of protecting wealth against inflation. Separate figures released by the ONS showed that UK house prices increased 2.9% in the 12 months to September, quicker than the rate of inflation across the economy as a whole.

“Property values tend to increase with inflation, with higher rents and replacement costs justifying the increase in values,” explains O’Neill.

However, actively investing in property in order to beat inflation isn’t an option for a lot of people as a large proportion of household wealth tends to already be tied up in a home.

For that reason, “building a strong investment portfolio with exposure to leading global equities and a judicious allocation to gold is the logical next step in creating generational wealth even when adjusted for inflation,” says O’Neill.

Real estate investment trusts (REITs) can offer more liquid access to real estate markets, but it is worth remembering that their performance can diverge from direct property investments as they are subject to stock market volatility. Investors should factor this in when deciding whether REITs are worth buying.

Stocks and shares

According to Craig Rickman, personal finance and pensions expert at Interactive Investor, stocks and shares are one way to hedge against inflation, especially over the long term.

“If the financial goal you’re saving for is five years or more away, and you’re prepared to take some risk with your money, the stock market should offer a better option to grow your wealth and hedge against the threat posed by rising inflation,” he says.

O’Neill suggests that investors should be selective in terms of their inflation-busting investments, though.

“Household names with pricing power (Heinz (NASDAQ:KHC), for example) can often eventually pass higher costs on to consumers and restore profit margins,” he says.

Additionally, “sectors such as healthcare will likely face strong demand regardless of inflationary pressures”.

Gold

Gold has been used as a store of value for nearly 6,000 years. Investing in gold is therefore one of the most tried-and-tested means of protecting wealth against inflation.

Historically, gold has “proven to be a good store of value during inflationary periods, despite its lack of income,” says O’Neill.

Gold prices have increased by over 32% in US dollar terms over the past year, and 30% against the pound. O’Neill points out that Bentley Reid has trimmed its position in gold on the back of these gains, though it still retains “moderate allocation given ongoing inflationary pressures and hefty government deficits”.

What is the long term outlook for inflation?

“Economists expect inflation to decline modestly to around 2.2% by the end of 2025,” says O’Neill.

Global energy prices have stabilised this year but ongoing geopolitical tensions mean that a spike could occur at any time. Similarly, labour markets remain tight; O’Neill says that “any renewed wage pressure particularly in areas such as healthcare, education and hospitality could cause inflation expectations to rise”.

Much will depend on the BoE’s own response. It is engaged in a delicate trade-off between stimulating growth by keeping rates low on the one hand and protecting against inflation on the other.

“It’s a difficult balancing act but one that central banks globally have managed very well this time around so far,” says O’Neill.