By: Phil Kernen

What should investors do when inflation comes to stay? The loss of purchasing power following a general price increase will upset the spending plans of any portfolio. Following are several commonly cited ways to protect against inflation, some more effective than others.

Treasury Inflation Protected Securities (TIPS)

The U.S. Treasury issues TIPS, bonds whose purchasing power adjusts with inflation through changes to principal and coupon payments. Assume you have a TIPS bond worth $1,000. Following a year of 7% inflation, your inflation-adjusted or real value of $930 reflects your lost purchasing power. However, the nominal principal value of the TIPS bonds, which determine coupon payments and funds received at maturity, will now adjust to $1,070.

While there are many ways to calculate inflation, the Consumer Price Index is the only method that applies to the principal adjustment of TIPS. While monthly changes in CPI inflation impact TIPS values more directly than any other asset on this list, TIPS values remain subject to changing inflation expectations and interest rate risks. You can learn more here.  

Series I Savings Bonds

Series I Savings Bonds work similarly to TIPS in that changes in CPI drive adjustments to the principal, and the U.S. Treasury is your borrower. But material differences exist. An I-Bond is a 30-year maturity whose interest rate resets every six months, whereas TIPS are available in various final maturities. You can cash out of your I-Bond any time after one year, but if you cash out before five years, you will forfeit three months of interest. You can sell TIPS bonds at any time without restrictions. I-Bond purchases are limited to $10,000 annually per person, but you can buy more if you include your spouse or company. TIPS bonds have no maximum purchase limits.  

Stock ownership

When companies face higher labor and material costs, they have two choices; raise selling prices to protect profit margins or leave selling prices unchanged and accept lower profit margins. Most companies pursue some price increases leading to higher revenues and earnings in an inflationary environment. Companies with strong brands will have greater pricing power than those with weaker brands. Years of marketing, brand building, and excellent customer service allow a longer runway for prices to rise before leading to substitution or outright dismissal.

Not every company exhibits pricing power all the time and in every kind of inflationary environment. For example, consumer-facing sectors may have strong pricing power under lower inflation and less pricing power as inflation exceeds certain thresholds as substitutions become more attractive options. Conversely, materials and commodity-related sectors often exhibit pricing power in most inflation environments as long as the economy expands. A company’s degree and depth of pricing power will dictate how stock prices behave under inflation, but stocks offer the substantial capacity to provide returns that exceed inflation.

Gold

Due to natural supply constraints, investors cite gold as a hedge against inflation, a commodity expected to increase in value as the purchasing power of the dollar declines. A 2013 National Bureau of Economic Research paper suggests such expectations are misplaced. The report builds on previous research from 1977, showing that gold has been a poor inflation hedge in the short run, typically viewed as the next few years. The report did acknowledge that gold appears to hedge inflation well over longer term periods like a century – much too long to be actionable. 

The key is whether asset returns effectively protect the portfolio against unexpected inflation. On that measure, gold performs poorly. Since 1975, gold posted trailing ten-year, annualized returns ranging from -6% to +20%. In contrast, inflation rates ranged from 2.3% to 7.3% over the same period, a material mismatch in return ranges. Inflation neither predicted gold returns nor did gold returns reflect inflation. As an inflation hedge, gold and most other commodities are lacking.

No perfect inflation hedge exists, but many options are available for investors to employ as needed. As with any other investment decision, it will come down to the needs, objectives, asset allocation, and investment horizon of your portfolio.

Disclosure: This is for informational purposes only, and any reference to a specific company does not constitute a recommendation to buy or sell that company. The reader should not assume that an investment in the securities identified or described was, or will be profitable.