Understanding Inflation and How to Protect Against It

Inflation is a significant concern for investors, especially those nearing retirement or with specific financial goals. As wealth managers, it is crucial to recognize the validity of these concerns and to implement strategies that protect clients' portfolios against inflation. This article will discuss the different ways to safeguard investments against inflation, the primary measures of inflation to watch for, and the role of hard assets in providing inflation protection.

1. Protecting Clients Against Inflation

• Direct Protection: One approach to protecting clients against inflation is to invest in government bonds with coupon payments indexed to inflation. These bonds generally offer lower coupons than nominal paying government bonds, reflecting their value in providing inflation protection.

• Indirect Protection: Another way to guard against inflation is to invest in assets that relatively outperform during inflationary periods. Common examples include hard assets such as commodities (oil, natural gas, steel, etc.), which can be accessed through synthetic funds designed to profit during inflationary times.

2. Treasury Inflation Protected Securities (TIPS)

• TIPS are a type of US government bond that offers direct protection against inflation. The principal of TIPS is adjusted according to changes in the Consumer Price Index (CPI), ensuring that the bond's value keeps pace with inflation.

• One drawback of TIPS is their relatively low coupon payments, making them less attractive to investors seeking higher yields. However, they can provide peace of mind for clients concerned about preserving their purchasing power in the face of inflation.

3. Two Primary Measures of Inflation

• Consumer Price Index (CPI): CPI is a measure of the change in the price of a basket of goods and services that a "standard individual" would purchase in a given year. It can be calculated on a quarter-over-quarter or year-over-year basis.

• Core CPI: Core CPI represents the same basket of goods and services as CPI but excludes food and energy due to their historical price volatility. Core CPI is often considered a more stable and reliable measure of underlying inflation trends.

4. Hard Assets as Inflation Hedges

• Commodities: Hard assets, such as commodities, have historically outperformed during inflationary periods, making them a potential hedge against inflation. By investing in funds that track the performance of commodities like oil, natural gas, and steel, investors can benefit from rising prices during inflationary times.

• Tech Stocks: Some investors have considered tech stocks as a potential inflation hedge due to their high growth rates and margins. However, this can be a risky proposition, as tech stocks may not always perform well during periods of high inflation.

Inflation is a legitimate concern for many investors, and wealth managers need to develop strategies to protect their clients' portfolios from its impact. By understanding the primary measures of inflation and incorporating inflation-protected assets into investment portfolios, investors can ensure that their financial goals remain on track, even during times of rising prices.