How Best to Hedge Against Inflation

To protect against inflation-driven loss of purchasing power, investors look to own assets that appreciate with inflation. These assets include gold, stocks, real estate, and, more recently, bitcoin. Assets purchased to protect wealth against rising inflation are referred to as “inflation hedges” and have been part of many individuals’ portfolios for many reasons.

Gold

Gold has a rich history of price stability and a proven track record of resilience during economic downturns. Additionally, gold has been praised for its sound monetary properties, including its scarcity, cost of production (i.e., difficult to inflate supply), durability, divisibility, and fungibility — making it an attractive store of value and a “safe haven” asset.

For example, the bullion outperformed virtually all other assets when inflation was high under the Carter and Nixon administrations. Pundits contend that Richard Nixon, the 37th US president (1969– 1974), nearly destroyed the US economy via his poor attempts to remedy mild inflation with wage and price controls, as well as removing the US gold standard. By the end of his tenure, inflation hit double digits, and gold was up +350% since the start of his first term.

Under Jimmy Carter, the 39th US President (1977–1981), inflation got as high as roughly

18% following the naming of Paul Volcker as Chairman of the Federal Reserve Board. Volcker attempted to end double-digit inflation by raising the federal funds rate to unprecedented levels. This extensive period of extremely high interest rates is now known as the “Volcker Shock” and was the primary driver of the 1981 recession. Between Carter’s inauguration and the end of his tenure, gold prices rose +148% as people flocked to the safe haven asset to protect their wealth.

Between major economic downturns, gold prices have historically trended lower before consolidating and then rallying higher as the next economic downturn begins to surface. Figure 16 describes how gold rapidly appreciates ahead of significant downturns before retracing lower and consolidating.

Bitcoin is often referred to as digital gold because its underlying computer code ensures many of the same properties of gold. Like gold, bitcoin is also highly scarce, supply inflation-resistant, divisible, durable, and highly fungible. Bitcoin is hailed as an inflation hedge because it isn’t subject to the uncertainty of a central bank’s monetary policy. Instead, Bitcoin creator Satoshi Nakamoto determined the crypto asset’s supply inflation schedule at the time of inception, and any changes to it would have to be voted in by the community rather than a centralized authority.

Moreover, it seems that the “smart money” is buying up bitcoin in troves since late last year, including legendary investor Paul Tudor Jones, MicroStrategy’s Michael Saylor, and Tesla’s Elon Musk. These billionaires, among others, have added billions of dollars worth of bitcoin to their company’s Treasury reserves and personal investment portfolios to hedge against impending inflation.

Institutions and renowned investors have historically stayed away from investing in bitcoin, citing claims that it is a risky and speculative asset. Though before the COVID-19 pandemic, bitcoin was too inexperienced to be an inflation hedge, its rapidly growing reputation — as evidenced by “smart money” buying into the asset — will likely solidify its spot as one of the best inflation hedges for the foreseeable future.

Stocks & Bonds

The relationship between inflation and equity prices is not uniform because stocks and the companies issuing them differ. While every stock should be evaluated on its own merits, many contend that value stocks (i.e., shares trading at a lower valuation relative to the company’s fundamentals, such as dividends, earnings, or sales) may do better than growth stocks (i.e., stocks that are expected to outperform the market) when inflation is high. This theory stems from investors assessing growth stocks based on their present value of future earnings. When growth in inflation or interest rates starts pacing faster than expected, it reduces the current value of future cash flows. Stocks that can defend high dividend payments, including many value stocks, are likely to outperform because their yield is relatively attractive.

Stocks can appreciate with inflation because it can stimulate job growth, investors may seek to hedge by converting cash into stocks, and revenues increase with inflation following an adjustment period.

Hyperinflation is Coming

Assuming high inflation is considered a rate greater than the average for post-gold linked currency exchange in the US since 1971 (i.e., 4.4%), stocks have on average fared significantly better than bonds during times of high inflation throughout history.

Out of these 20 years of high inflation, bonds have yielded a positive return for only six years (30%) while stocks finished higher for 11 (55%). However, one should note that the average return for stocks (+2.5%) was still less than the average inflation rate (6.4%) during these 20 years.

Although stocks are typically a better inflation hedge than bonds and fiat currency, they have struggled to completely protect one’s wealth from inflation in the past.

Inflation can also adversely affect stock prices because declining consumer spending during general economic slowdowns leads to lower revenue and profits that weigh on share prices. Also, increases in input costs (cost-push inflation) can decrease profit rates and force businesses to falter as it takes companies several quarters to pass along input costs to consumers.