5 ‘inflation-proof investments’ to protect your UK portfolio

Inflation is when prices of goods and services rise in an economy, meaning it takes more currency to buy the same things. It’s associated with positive interest rates as central banks tend to hike interest rates in an effort to combat excessive inflation. Some inflation is quite common. Prices, which are measured by the consumer price index (CPI), tend to rise a percent or two per year in many countries.

If investors make returns that are higher inflation, then they are making a real rate of return and inflation is not eroding their capital. If their investing strategies​ make less than inflation — for example, they make 0.25% in a savings account, and inflation is 2% — then their capital is eroded and they are losing purchasing power in real terms.

Inflation isn’t bad, and it can be beat over the long run with certain types of investments. Hyperinflation, which is rapidly rising prices, typically of 50% or more per month, is a more severe situation but is extremely rare in developed countries over the last 100 years.

Inflation occurs because prices chase money supply. Increasing money supply creates inflation. Central banks play a role in this by pumping money into the economy during times of economic stress. They do this to help avoid a financial collapse, but at that same time, that money being pumped in can create inflation over time.

Inflation is a fact of life much of the time. Next, we’ll look at how to invest to stay ahead of inflation, and how inflation affects those investments.

What do you invest in during inflation? There are several investments protected from inflation, and that provide inflation-beating returns. Some will perform better in rising inflation, while others will perform better in steady inflation. Rising inflation is when prices and interest rates are increasing by larger percentages over time (1%, 3%, 5%, and so on). Steady inflation is when prices are increasing roughly the same amount: say 2%, each year.

Please remember that past performance is not a reliable indicator of future results.

Stock indices, such as the FTSE 100 or S&P 500, have previously averaged 7% to 10% per year over the long term. Therefore, they are one of the best inflation-fighting asset classes for passive investing (buy-and-hold).

Stock indices tend to perform well when inflation is steady. Stock indices tend to struggle more when inflation is rising, especially once interest rates get above 6%, but that is not always the case. Therefore, stocks remain a staple in most investor’s portfolios for beating inflation in a wide range of economic conditions.

Stock indices include stocks that pay dividends. The return generated by dividends also helps to offset inflation.

Consumer staples is a sector of the stock market that includes companies providing essential products such as toilet paper, toothbrushes, deodorant, cleaning supplies, and so on. These types of companies are more resistant to inflation, since their products are in demand no matter what. They can increase prices on their goods as inflation rises with minimal effect on sales/demand.

In times of rising inflation, consumer staples may provide a hedge against it. Before investing, learn how to invest in stocks​.

If inflation is rising, that often means commodity prices will be rising because they are direct inputs into many other products. Commodities include cocoa, coffee, oil, natural gas, sugar, corn, precious metals, and so on.

Commodity prices are often (but not always) tied to inflation. If inflation is rising, commodity prices tend to rise, producing returns to hedge or beat the inflation. When inflation is steady, commodities may not necessarily be under upside pressure. Therefore, some may look to commodities like gold and oil in ETFs when inflation/interest rates are trending higher.

Gold has a checkered history of being an inflation hedge; sometimes it works, sometimes it doesn’t (read more in our article on gold ETFs​). Oil tends to have a better track record of moving higher as interest rates/inflation move up as it benefits from increasing economic activity which is sometimes the cause of the inflation.

Over the long-run, real estate prices increase along with steady inflation, often beating it. While the returns vary by region and country, most averages put real estate appreciation at 3-4% per year, which beats low levels of steady inflation.

If inflation is rising, interest rates rise, and then means people can afford to borrow less to spend on houses than they did before. This tends to push housing prices down. Therefore, real estate or REITs may not perform as well in rising inflation, but are good for periods of steady inflation and low interest rates.

Rental REITs may be a corner of this asset class that can still perform well in times of rising inflation, since rents can be increased to account for higher costs of living during such times.

Bonds can beat inflation during steady inflation. For example, if you buy a 3% bond and inflation is holding near 2% or below, then that bond offers an inflation-beating return.

Bonds may underperform if you buy bonds and then inflation or interest rates rise. If inflation rises to 4%, the 3% bond is losing money in real terms. Before buying an asset, consider if now is a good time to invest​.

Inflation adjusted or linked bonds are issued by the UK (sometimes referred to as “Linkers”), and other governments, and offer extra inflation protection. As inflation rises, the par value of the bond rises to compensate the investor. The value can also drop in deflation, but not below the original par value.

These are assets that struggle during times of inflation, and may lose value in real terms. But inflation and interest rates are not the only factors that affect asset prices.

Cash is often seen as one of the worst investments during inflation by investors. A short-term investment​ such as a savings account that pays a small amount of interest will typically be losing purchasing power to inflation. That cash will buy less in the future. By investing and growing that cash, there is more of it to buy higher-priced goods in the future.

Bonds become less attractive and lose money in real terms if interest rates rise. Making 2% on a bond is very attractive when interest rates are 0.5%. This return becomes less attractive when interest rates are 6%. Inflation-adjusted bonds help compensate for this.

Real estate prices may fall when interest rates rise aggressively. With higher interest rates on mortgages, people can’t afford to borrow as much to buy a house. For REITs that own real estate, this may likely push their value down as well. This effect could be offset by high demand for houses, keeping prices up, or increasing wages which allow people to afford the higher interest rates on borrowing for homes.