What higher inflation will mean

1% interest rate insufficient to meet the income needs of most in retirement, but when you also take into account the impact of inflation (which historically runs at 2.5%pa in Australia), many retirees are guaranteed to lose money on an inflation-adjusted basis each year in their term deposit and bond investments.”

As Ray Dalio, founder of the global hedge fund Bridgewater Associates, puts it: “Cash is trash. It looks like a low-risk thing to hold, but it’s not. When you have a zero interest rate and an inflation rate of 2% or higher, you get taxed – essentially lose – buying power at 2% a year.”

Investment-grade bonds are also left wanting during reflationary environments. Their fixed income stream via coupon payments has diminished purchasing power.

And it’s not just the income stream – the value of existing bonds falls on the secondary market, eating away at the asset base of fixed-income investors. And with a fall in bond prices comes an increase in yields.

“This would be negative for tech stocks (as they have long-duration earnings) and bond proxies such as utilities, telecommunication and property stocks,” says Oliver.

Rotate your holdings

Hedging against inflation will require rotating out of some of the assets mentioned. But you don’t want to overdo it because assets that perform well during inflationary environments often don’t do as well during low inflation.

“Don’t lock your portfolios into a high-inflation environment and build just for that, because if you get that question wrong your portfolios will be incorrectly built and you’ll lose out on return,” says Kieran Canavan, chief investment officer at Findex Group, an Australasian financial advisory and accounting group. “But when inflation comes, you need to rotate your portfolio.”

Because fixed income is the asset class most affected by inflation, so it makes sense to start there.

Bonds with shorter durations (the length of time between when a bond is issued and when the face value is paid back to the bond holder) are less susceptible to increases in interest rates – the standard central bank play to put inflation back in the box.

Moving to lower-duration bonds rather than to higher-yielding but low-quality bonds, is the way to go, according to Michael Abrahamsson, from Melbourne-based Flinders Wealth. “Short-duration, high-quality bonds provide some comfort versus long-duration, lower

quality bonds,” he says. “From experience, lower-quality bonds provide higher interest rates for a reason, [with] heightened credit risk increasing the likelihood of default.”

Other alternatives here could include inflation-linked bonds (ILBs), which have coupon payments that are adjusted in line with changes to the consumer price index.

However, ILBs are not a one-stop bond shop for guarding against inflation. “The opportunity cost of investing in ILBs is that when other asset classes outperform, returns on ILBs are more likely to simply keep pace with inflation,” says Abrahamsson.

Equities provide another good diversifier, to varying degrees depending on the length and strength of inflation.

Research from Schroders found that US equities perform best during low and rising inflation, outperforming 90% of the time during these phases. By contrast, US equities underperformed over half the time when inflation was above 3%.

“We find equities aren’t good short-term inflation hedges, but they tend to be a good inflation hedge over the long term,” says Canavan.

Additionally, “if you get rates going up because of growth, equity markets tend to be relatively resilient in that environment, but when you have rates go up because of monetary policy, you tend to get very wild swings.”

Canavan prefers companies that generate rather than consume cash – price setters with high barriers to entry, where you can increase the volume of sales without significantly increasing costs.

Commodity stocks, from oil to iron ore, have long been viewed as an effective inflation hedge given they largely contribute to, rather than shoulder, higher input prices. Similarly, property offers a decent inflation hedge due to the pass-through of price increases in prices.

But gaining this exposure doesn’t necessarily mean investing in property.

Gerrard points to first-registered mortgage investments. “Several non-bank lenders allow external investors to participate in the loan deals they fund and typically pay interest less their clip, which is usually 1%-2%. Investors can expect 5%-7% interest in 50% loan-to-value ratio deals over first-registered property loan deals in metropolitan Sydney and Melbourne.”

Then there’s gold, which is adept at hedging without forgoing performance if things turn out to be better than expected.

“It’s always been an inflation hedge. In the last nine months there have been heightened concerns about inflation, and high inflation expectations are typically good for gold,” says Jordan Eliseo, manager of listed products and investment research at Perth Mint.

“The overall correlation between gold and equities is very minimal, but if you just look at when the equity market rises then gold is positively correlated in those environments, it just doesn’t go up as much as equities do.”

No single investment provides a panacea against inflation. Sure, you could put all your wealth into an asset known for its resilience during inflationary periods, but you would take on concentration risk. In this sense, the cure shouldn’t be worse than the disease.

“Some asset classes traditionally recommended as inflation hedges might be quite risky under certain circumstances, especially when used as standalone solutions,” notes research by Charles Schwab Investment Management. “… a thoughtful, well-diversified approach is the most effective means to prepare for inflation.”

“Cash is trash. It looks like a low-risk thing to hold, but it’s not”