After nearly three decades of low levels, inflation has recently emerged as a primary concern for investors. Rising inflation means falling purchasing power, and the most recent Consumer Price Index report showed inflation rising at its fastest pace since August 2008, just before the depths of the financial crisis.
As the global economy and financial markets have begun recovering from COVID-19, inflation has surged due to supply chain backups and extreme demand driven by many peoples’ desire to get back to “normal” activities and make up for time lost due to the pandemic. As a result, food, energy, commodity and housing prices continue to skyrocket.
Additional Equity Exposure
Historically, the best hedges against inflation depend on an investor’s specific time frame, with commodities like gold often considered a reliable option. But how else can traders and investors hedge their equity exposure to rising inflation?
While there are many potential inflation hedges, there are a few that offer greater simplicity of trading. Since equities have outperformed almost all other asset classes over time and have generated high inflation-adjusted returns over the long term, additional exposure to the equity space can be of value. A key reason stocks can flourish in a modest inflation environment is that companies, especially big ones, can often pass along cost increases. Additionally, corporate earnings often grow faster when inflation is higher as this indicates people are spending and the economy is growing.
Equities can be an efficient hedge against the loss of purchasing power because the real asset to owning equities is their future earnings stream, which is priced in future dollars.
Increased Liquidity, Reduced Risk
But many stocks are at or near all-time highs and valuations may appear to be expensive, so rather than choosing individual equities, a trader may opt to use CME Group’s Micro E-mini Equity Index contracts to hedge their portfolio.
Micro E-mini contracts are offered at 1/10 the contract size of E-mini contracts and can be converted both ways at a ratio of 10:1 or vice versa. Prior to the launch of Micro E-mini contracts, futures traders could adjust their exposures, hedge a position, or move into other positions, but not as precisely as they might desire. Now, traders can actively manage their strategies with greater precision and ensure that their portfolios are properly allocated in all market conditions. Not only do the smaller contract sizes provide liquidity and flexibility, they are designed to reduce traders’ risk during more uncertain and volatile times like this current inflationary period.
A Safer Security
Treasury Inflation-Protected Securities (TIPS) are government bonds that mirror the rise and fall of inflation and are designed to increase in value in order to keep pace with inflation. The bonds are linked to the Consumer Price Index and their principal amount is reset according to changes in this index. When inflation rises, so does the interest rate paid. And when deflation occurs, interest rates decline.
TIPS pay interest twice a year at a fixed rate, and they are issued in 5-, 10- and 30-year maturities. At maturity, investors are paid either the adjusted principal or the original principal, whichever is greater.
The Bottom Line
For investors concerned with protecting themselves against inflation, whether or not it’s “transitory,” as Fed Chair Powell has called it, one option is to increase portfolio exposure to equities. This can be done in a more precise fashion using Micro E-mini contracts. And another method is purchasing interest rate-sensitive government bonds known as TIPS.
But the bottom line is that whether an investor chooses one or both of these – or a different alternative entirely – there are options for hedging against rising inflation and declining purchasing power.
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