Four ways to keep inflation at bay

With news inflation jumped to 4.4% in February and gold prices still soaring, Joanna Faith looks at some alternative hedges.

Inflation is dominating headlines once again with the annoucement the UK Consumer Prices Index (CPI) annual rate of inflation has risen to 4.4%, up from 4% in January and more than double the Bank's target of 2%.

The higher-than-expected increase comes just a day before George Osborne unveils his Budget and compares with a figure of 4.2% forecast by a 32-strong group of economists.

Industry commentators had warned spiralling inflation would be a prominent trend in 2011 with Investec stalwart John Stopford saying inflation will be one of the three dominant themes this year.

So what does this mean for investors? Traditionally, gold has been considered one of the best hedges against inflation.

But with fears of the gold price rising too high – it was recently trading at about $1,400 an ounce, up from less than $500 five years ago – and a bubble emerging, where else can investors look to hedge against inflation?

1. Index-linked securities

Index-linked securities offer the purest form of protection against inflation, according to Jim Stride, AXA IM’s head of UK equities. From a UK perspective, this means investing in index-linked gilts where both the coupon and redemption prices are linked to changes in the RPI.

“There has been some discussion as to whether or not there should be CPI-linked inflation bonds, but that will not be broached until the next financial year,” says Stride.

“So, in the meantime, if you buy an index linked gilt today and hold it to maturity, you will receive a return greater than the rate of inflation.”

Architas CIO Caspar Rock agrees, saying the asset class “is the default” hedge against inflation “over the very long term”.

However, he adds there are problems with index-linked securities. “They are very long duration assets,” he says.

“With bond yields as low as they are, if there is an interest rate rise, you have a big interest-rate duration bet in the portfolio.”

As a solution to this problem, he recommends AXA IM’s Redex fund share class, which is designed to reduce interest rate risk. Redex was launched last year initially in the AXA WF Global Inflation Bonds fund.

It allows investors to benefit from a fund’s active investment strategy, while mitigating their exposure to interest rate risk based on the implementation of an overlay strategy

Meanwhile, Matthew Philips, investment director at BDO IM, says a lack of issuance is another problem with the asset class. He says over the past two to three years, a lot of pension funds have been buying them up to meet their inflation linked liabilities, so the market is quite thin. “This makes them quite expensive because there is not a lot of issuance, but this is not a particularly new issue,” he says.

2. Commercial property

Long-term records suggest land is a good hedge against inflation, says Stride. In theory, property rents should rise as inflation increases. But, he adds, this does not always happen.

“The problem with property, as in bricks and mortar, is it is illiquid and subject to very rapid fashion change,” he says.

“The same is true of property shares to some extent, but at least they are bite-sized. If you have to sell £50,000-worth of property it is easier to sell shares than part of a £20m building.”

Philips agrees property is one of the classic hedges against inflation.

“If you have good tenants and strong rent reviews every three or five years, you’ll have income from tenants going up by more than inflation or at least being inflation-linked. But he cautions that property should be a long-term hedge, because it is not a one-way bet and prices are fragmented.

3. Equities

Rock believes buying high-quality equities with growing dividends is another sound inflation hedge. Philips agrees, saying over a five-year period, the vast majority of equities will outperform inflation.

However, he warns this is not an immediate hedge. Stride believes the asset class only offers inflation protection in the “very long term”.

He says you run the risk of very high volatility and the key is to be in dividend paying equities as most of the return in real terms is likely to come from dividends in the long run.

4. Commodities

Any form of commodity investment – be it in base metals or soft commodities – will give some measure of inflation protection, according to Julian Chillingworth, CIO of Rathbone Unit Trust Management.

Because commodities prices usually rise when inflation is accelerating, they offer protection from the effects of inflation. Chillingworth recommends accessing the asset class via ETFs or a soft commodity fund such as the one offered by Goldman Sachs.