Hedging against inflation

C&C VIEWS By Ed F. Limtingco Updated December 17, 2008 12:00 AM

My former boss, Dr. Cayetano W. Paderanga Jr., has forwarded me this timely piece of write up that is not only relevant but is also informative. This piece was taken from IDEA’s latest Economic Trends.

According to IDEA, “inflation hedges can be defined as investment instruments designed to protect against inflation risks. During periods of high inflation, ordinary investment instruments yield lower returns as high inflation inevitably leads to an erosion of their earnings’ value. On the other hand, the underlying value of such inflation hedges typically increase during times of high inflation. Commonly cited inflation hedges are shareholder stocks of companies engaged in the natural resources industry, such as the mining of precious metals like gold or silver. Following developments in the financial sector, newer investment assets have become popular as inflation hedges. For example, money market funds that pay higher yields as inflation rises are now believed to be good inflation hedges. In times of hyperinflation, however, hard assets like precious metals and real estate are considered to be the safest inflation hedges available. Paper-based assets like stocks and bonds have been found to be poor hedges during times of hyperinflation.”

Furthermore, it was reported that “since inflation inevitably leads to lower purchasing power, investors look for ways in securing their portfolio value while yielding decent returns in the short run. This is where investments in precious metals—gold, in particular—come in. For risk adverse investors, especially those whose life cycle prevents them from absorbing more risks, safer investment assets are now available in the market. For one, index-linked financial instruments offer annuities that are tied to a basket of consumer goods or the consumer price index (CPI). This type of inflation hedge is commonly used for pensioners whose retirement annuities promise a certain level of returns. Because of this, index-linked financial instruments are justifiably the near-perfect inflation hedge. Though these bonds are effective cover against inflation, their long-run returns are expected to be lower relative to nominal bonds since holders of the latter would demand higher interest in exchange for bearing more risks.”

Lastly, it was said that “though rates have been fairly stable since 2003, there was a drop in the yield curve rates in early 2008. This happened as investors quickly shifted their funds to safer US government securities as the extent of the damage suffered by Wall Street stemming from the mortgage crisis unfolds. Investors are willing to receive yields below 0.5% in exchange for the guarantee of safe investment return. A note of caution, though. Since these bonds are tied to the domestic currency, it would make sense for foreign investors to invest in these instruments if the respective foreign currencies maintain purchasing power parity. Since adjustments for these bonds depend on a six-month lag, investors are still not spared from losses no matter how small it may appear to be,” according to IDEA.

According to IDEA, “since common stocks often offer higher returns than fixed-income instruments do, some analysts believe that it is a good inflation hedge. Based on historical performance, however, equities and fixed-income assets often yield lower returns during high inflationary periods. Since common stocks represent ownership of real physical capital, their rate of return is higher than inflation in the long run.

By staking a claim on real capital, owners of common stocks find refuge from high inflation. In a 1976 Zvi Bodie study, stock returns in the United States were found to be negatively correlated to a small degree with historical inflation.

Because of this, doubts remain whether common stocks can really be an effective inflation hedge, most especially in the short run. Its main strength is the likelihood that it yields higher returns in the long run compared to commercial paper. This potential for bigger earnings, however, also comes with the possibility of higher loses in instances when a crisis hits the financial sector, as now seen in the US.”

Furthermore, according to the same report, “except during the first and second oil price shocks, the S&P 500 generally generated higher returns, way above actual inflation. Because of the stock market’s historical performance, some investors continue to believe that this particular asset is a good inflation hedge. Like other commodities, the verdict on whether real estate offers better options for investors remains to be seen.

Unlike gold, however, real estate assets suffer from poor liquidity, making it problematic for investors to leave the property market once volatility sets in. Based on a 10-year average, the returns of the NCREIF index reached 12.7%, way above the S&P 500’s 8.4% and the 91-day treasury’s 3.6% yield.

Like in all other assets, historical performance is no guarantee of future performance. In the case of real estate, the mode of acquisition of the property becomes a crucial factor. Unless paid in full, real estate depends on mortgage financing which often have adjustable mortgage rates (AMRs).

This becomes problematic since investors face interest rate risks, possibly wiping out their returns and putting them deep into debt. This is one hard lesson property owners now face in the face of the ongoing mortgage crisis that has put the US economy in a likely recession.”

Overall it was reported that “to become effective inflation hedges, assets need to be able to maintain their value in the face of high inflation. Decades before the introduction of the index-linked bonds, gold was considered to be the best inflation hedge.

This belief largely explains gold price movements during the 1970s and 1980s. The onset of the US Treasury’s TIPS and other similar index linked bonds have reduced the place of gold as an important inflation hedge. Given other issues such as tax obligations and asset allocation, investors will have to be more careful in making decisions especially now in a highly uncertain environment” according to IDEA.

For credit & collection (C&C) questions, comments and rejoinders you want to share or inquire, you can reach him at 0917-7220521 or at elimtingco@cibi.net.ph