How to protect yourself against inflation

Inflation can be seen as a stealth tax. It erodes the value of your savings but it does not affect everyone to the same extent, for debtors inflation can be good. The official inflation in most countries is low at the moment but some economists worry that the inflation will soon start to increase. But can you protect yourself against inflation?

The short answer is it is very difficult to protect yourself against inflation. Several studies have shown that inflation tends to erode the value of most assets. There is also a practical reason why it is difficult to protect yourself against inflation, you don’t know what the inflation will be in the future. If you know for sure that inflation will increase drastically in the future, you could make a fortune by buying real estate in good locations and borrowing as much as possible at fixed rate. But such a strategy is would backfire badly if the economy would slow down. Deflation could kill you financially.

No one knows what will happen in the future but obviously some scenarios are more likely than others. We can simplify things and look at four possible outcomes. First we have the risk of depression with deflation. This is what governments and central banks are trying to avoid, almost at all costs. Deflation is certainly possible, but not very likely. Next we have the preferred outcome for many, a sound economy with a little bit of inflation, about 2 to 4 percent. Unfortunately, at the moment this looks very much like wishful thinking. Higher inflation looks more likely, say between 6 and 10 percent. The last case, hyperinflation or very high inflation, is something governments want to avoid but if they would have to choose between deflation and hyperinflation, the latter would be preferred. Hyperinflation would cause a lot of pain but it would at least wipe out government debt.

Gold has been the classic protection against inflation but things have become more complicated. Inflation does not seem to have much influence on the gold price nowadays, instead speculation seems to drive the gold price. Still, in times of high inflation gold is likely to provide some protection. One big drawback with gold is that it does not pay any dividend. And in turbulent times, cash flow is very important.

Bonds have generally been classified as a losing investment when inflation is high. Actually, this is only partially true. Government bonds that are linked to inflation, called TIPS (Treasury Inflation Protected Securities) in the US, provide good protection against high inflation. Unfortunately, most governments understate the true rate of inflation, making these bonds less good against inflation. One interesting thing about index-linked bonds is that the Bank of England pension fund has invested 95% of its assets in index-linked bonds. This is very odd given that the BoE’s official view is that the inflation will stay low, less than 2%. With such a low inflation, index-linked bonds are not a very good investment. Does the BoE expect much higher inflation in the future?

Shares have beaten the inflation over time. But that does not automatically make shares a good hedge against inflation. Historically, shares have performed best in moderate inflation. High inflation has created trouble for shares, maybe because interest go up or maybe because not all companies can protect themselves from inflation, in essence, they can’t pass on the increased costs to their customers. But we are taking about average returns, obviously some shares will perform better than others during times of high inflation. The standard recommendation is to invest in blue-chips which pay high dividends.

Real estate has become very popular and a lot of people think that property will protect them against inflation. This is to some extent true. Obviously, the term real estate covers a lot of different types of property. But as protection against inflation, residential real estate in good locations typically provide the safest protection. Unfortunately, such properties are seldom cheap. The advantage of residential property is not only that inflation is likely to increase their value but also that rents will increase, improving your cash flow.

Trying to draw to many conclusions from the past can be dangerous, especially this time. Central banks will most likely try to keep interest rates down, even if inflation increases which may benefit shares. QE is also something that has never been tried before on this scale.

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