Inflation Hedges

During the reign of King Nebuchadnezzar (around 600 BC) an ounce of gold would buy around 350 loaves of bread, according to the Old Testament.

Gold has maintained its purchasing power for much of the intervening period between Nebuchadnezzar’s reign and today, continuing to buy around 350 loaves of bread per ounce. That’s one of the reasons investors view gold as a good store of wealth.

Gold has certainly provided a good hedge against inflation over the last 30 years, as the chart below shows. Indeed over the last few years the gold price has risen sharply as investors have sought a safe haven during a time of economic uncertainty.

Some believe gold now looks expensive, and when we return to ‘normal’ economic circumstances the price may lag any further rise in the cost of living. However, in the meantime the price is likely to remain high, and could climb even further in the short term as Western nations continue to devalue their currencies by printing money (quantitative easing).
One investment which has a built in ‘hedge’ against inflation is index-linked gilts; returns increase each year in line with the Retail Price Index (RPI), a commonly used inflation measure.

Index-linked gilts have performed respectably over the last 30 years, as the graph below shows, comfortably growing ahead of the rate of inflation, though please note these figures include the reinvestment of any income, which has boosted returns. However, index-linked gilts are sensitive to changes in interest rates, and when interest rates start to rise once again they could fall in value. While we do not anticipate any rise in interest rates in the short term, they could start to rise once a sustained economic recovery is underway.
Investors prepared to take more risk and accept more volatility could consider looking at companies which can increase the price of their goods (and profits) in line with inflation. If the cost of the materials they require to produce their products increases, they can usually pass on higher costs to their customers in the form of higher prices.

Furthermore, well-managed companies will grow their profits above the rate of inflation, by controlling costs or improving their products, and investors should benefit through rising dividends. A higher dividend can attract investors to the shares, pushing up the price, so existing investors could also enjoy some capital growth, although at times the price will still fall. One of our favourite long-term investment strategies is to reinvest dividends to benefit from a ‘snowball’ effect, so more dividends are earned on an ever-increasing number of shares.

This strategy would have provided an excellent hedge against any increase in the cost of living over the last 30 years, and far superior to gold and index-linked gilts, although as the graph shows the value fluctuates and so it is possible to lose money.
We believe this ‘equity income’ approach to investing should be the cornerstone of almost any investment portfolio. The hard part is deciding which shares to hold. With 97 of the 100 shares in the FTSE 100 currently paying a dividend there are plenty to choose from. Then there are higher risk smaller and medium-sized companies – and overseas firms too – many of which pay healthy dividends to their investors.

Equity income funds could provide a convenient solution. They are run by a professional fund manager who chooses the underlying stocks for you, and offer access to a diversified portfolio of typically 60 to 100 stocks, spreading your risk. They are also cost-effective when compared to the transaction costs of buying and holding a significant number of shares yourself or the cost of re-investing the dividends.

Finally, they have the added advantage that the dividend gets re-invested very quickly and you are not left waiting for the dividends to build up to a level where it becomes cost-effective to invest.It is important to remember all stock market investments will fluctuate in value and so the income and capital is not guaranteed.