How to Protect Your Portfolio Against Inflation

Inflation can significantly reduce the real returns of your investments over time, making it a key concern for any serious investor. As prices rise, the purchasing power of your portfolio may decline unless you take strategic actions.

This post will therefore discuss the importance of inflation, its relationship with interest rates, and will provide perspective on various economic conditions to help you understand inflation trends and how you can hedge your portfolio against inflationary pressures.

Importance of Inflation

Inflation is the average change of the price of goods and services, which is measured by the consumer price index (CPI). Inflation can also be thought of the change in the money supply for a particular nation. As the money supply increases, each individual dollar will have less purchasing power (meaning a weaker dollar), which tends to cause rising prices.

Inflation steadily erodes the value of your currency over time, as tools like the U.S. inflation calculator clearly show. The consumer price index (CPI) and money supply are closely connected, with increases in the CPI typically following shortly after the money supply grows.

For reference, the live CPI chart is shown below:

The Federal Reserve (aka the Fed) and most economists agree that the average target inflation rate should be between 1-3% (as highlighted in the chart above). A 0% rate is unrealistic because businesses, both private and public, need flexibility to adjust their prices for competitive reasons or to maintain profit margins.

Inflation is a natural byproduct of a growing economy, though the resulting loss in purchasing power for consumers makes inflation generally viewed as a "bad thing." Regardless, when inflation stays within the 1-3% range, businesses and consumers can make sound financial and investment decisions, contributing to a well-functioning economy.

When the inflation rate falls below 0%, this is called "deflation." Historically, deflation periods bring economic stagnation and higher unemployment due to reduced spending power from businesses and consumers as prices and wages fall. Most economists therefore agree that a low, stable inflation rate is preferable to either deflation or hyperinflation.

Hyperinflation refers to extremely high inflation rates. The International Financial Reporting Standards (IFRS) defines it as cumulative inflation of more than 100% over a 3-year period, which equals roughly 26% inflation each year for three years. Hyperinflation devastates economies by making cash nearly worthless, causing people to hoard essential goods, and preventing most investments from generating real returns.

Inflation and Interest Rates

To better invest in an inflationary environment, recognizing the key relationship between inflation rates and interest rates is critical. This requires understanding how the Fed influences both.

Put simply, the Fed has a "dual mandate" with two main responsibilities:

• Maintain price stability: Accomplished by keeping inflation between 1-3% over the long term.
• Maximum employment: Accomplished by supporting conditions for a strong labor market.

The Fed fulfills these responsibilities by controlling the money supply and influencing interest rates.

The "overnight lending rate" or "federal funds rate" is the specific interest rate the Fed controls. Commercial banks use this rate when lending money to each other short-term. This rate serves as the foundation for our entire financial system. When this rate rises, banks must increase interest rates on consumer loans (mortgages, credit cards, car loans, etc.) to cover their own higher borrowing costs.

If inflation climbs too high, the Fed raises interest rates, making borrowing more expensive and discouraging spending. When inflation falls too low or becomes deflation, the Fed cuts rates to encourage borrowing and stimulate economic growth. While interest rates influence inflation, the money supply is another key factor—a larger money supply tends to lower interest rates, while a smaller supply typically raises them.

Related: How Interest Rates Affect the Market

When the Fed announces interest rate increases, stock markets typically decline. Higher rates make credit more expensive, limiting growth for businesses that rely on financing. Similarly, higher inflation can drive stock prices down short-term. However, these market adjustments may create buying opportunities for investors.

Changes in the relationship between inflation and interest rates significantly impact different industries and asset classes, as we'll discuss later. Importantly, even experts struggle to accurately predict future interest rates and inflation levels. Professional interest rate forecasters have consistently had difficulty predicting where rates will move.

Factors That Affect Inflation

Besides the Fed changing interest rates, two main factors can cause higher inflation or even hyperinflation:

1. Money supply
2. Supply and demand

Investors can analyze these factors to assess current market conditions, which helps with investment allocation decisions.

Note: Hyperinflation is driven by an excessive money supply and extreme supply and demand imbalance.

Money Supply

The money supply represents the amount of cash and liquid assets in the economy. Stimulus payments add to this supply. In theory, more money circulating throughout the economy increases the chances of higher inflation.

For example, the $5 trillion pandemic-era stimulus from March 2020 to March 2021 was substantially higher than previous aid measures, as shown in the spike in the live chart below:

This massive increase in money supply contributed to higher inflation levels, as seen with the sharp rise in 2022. Fortunately, the Fed can quickly shrink the money supply by raising bank reserve requirements in the U.S., reducing the amount of money in circulation and helping lower inflation.

Velocity of Money

When examining money supply, another important factor is the velocity of money—the number of times a single dollar is used to buy goods and services over a specific period.

For example, if everyone in the U.S. received $1,000 but kept it in bank accounts rather than spending it, inflation levels would barely change. In such a scenario, the stock market would likely rise instead.

The live M2 velocity of money chart is shown below:

The velocity of money formula is shown below:

VM = GDP / M

where:

• VM = velocity of money
• GDP = gross domestic product (nominal)
• M = money supply

Some economists consider the velocity of money less relevant due to how it's calculated, arguing that credit creation and spending matter more than how often money changes hands. Nevertheless, velocity remains a useful indicator when the Fed significantly increases the money supply, as rising velocity can signal approaching inflation.

Supply and Demand

On the supply and demand side of inflation, the COVID-19 pandemic disrupted both significantly. Supply chains and delivery services became more expensive due to global lockdowns. Meanwhile, people began saving more money than ever before, largely because of stimulus checks, as shown in the live chart below:

The Fed's "transitory inflation" argument suggests that the pandemic created substantial "pent-up" demand, and combined with recovering global supply chains, this temporarily raised prices. According to this view, higher inflation is only temporary until the economy recovers further, at which point the Fed may increase interest rates to lower inflation.

Investors should recognize that this pent-up demand will likely continue growing as the economy reopens, potentially causing a rapid flow of money from consumer savings accounts into the economy. This could create an imbalance between supply and demand, leading to higher inflation that investors should prepare to hedge against.

Other factors that signal higher or lower inflation, mostly related to economic supply and demand, are discussed below.

Bond Market

When higher inflation is expected, bond prices typically fall while bond yields rise. As the economy recovers, investors often move toward riskier assets like stocks instead of bonds. This weaker demand for bonds leads to higher yields (to attract investors) and signals that the market anticipates higher future inflation.

You can check the U.S. 10-Year Treasury yield chart to see if this trend is occurring. At the time of writing, bond yields have increased over the past year.

Breakeven Inflation Rate

The breakeven inflation rate chart provides a measure of market-anticipated inflation. It shows the difference between 10-year treasury constant maturity bonds and 10-year treasury inflation-protected (TIPS) bonds. This comparison reveals what the market expects inflation to average over the next 10 years, plus a risk premium for uncertainty.

The live chart below shows the breakeven inflation chart:

While the breakeven rate might seem like a good inflation predictor, it actually has little relationship with future realized inflation. It better reflects current market sentiment rather than accurately predicting future inflation.

Unemployment

Lower unemployment rates often signal wage growth, increased consumer spending, and higher prices. When unemployment is high, inflation concerns typically decrease.

For reference, the live unemployment rate chart is shown below:

Commodity Prices

Commodity prices serve as leading indicators for expected inflation, reflecting both economic shocks (increased demand) and systematic shocks (disasters), which typically mean lower supply and higher costs. When commodity prices rise, this often indicates strong global demand relative to supply, suggesting possible higher future inflation. Websites like IndexMundi track these price movements.

Key commodities to watch include:

• Lumber and Steel: These materials affect construction and housing prices significantly. Framing materials make up about 18% of new home construction costs. When demand for lumber and steel rises faster than supply can adjust, construction costs increase, signaling broader inflation and rising costs for other raw materials.
• Oil: Oil impacts the entire economy and is used to make plastics found in many products. Higher oil prices typically increase transportation costs throughout the supply chain. These costs particularly affect the travel industry, though strong consumer demand for travel can sometimes absorb these price increases.
• Corn: Used in many food and industrial products and as livestock feed, corn price movements have widespread effects. When corn prices rise, this often leads to higher consumer prices for many food products, contributing to overall inflation.

Inflation Mentions

To provide an example of inflation mentions, Bank of America reported in April 2021 that "inflation" mentions in S&P 500 earnings calls had more than tripled year-over-year per company, reaching levels not seen since 2004.

BofA Global Research claims that inflation mentions historically lead the CPI by one quarter, with a 52% correlation.

This trend appears in the chart below:

Investments for Inflation Protection

Now that you understand inflation, the relationship between inflation and interest rates, and what factors lead to higher/lower inflation, let's examine how to invest when inflation moves outside the normal 1-3% range in the U.S.

The perfect inflation hedge would be an asset that:

• Rises with inflation
• Responds to unexpected inflation
• Maintains stable value
• Provides positive returns after accounting for inflation

Since no single asset meets all these criteria, investors should consider several options that offer partial protection. The chart below shows various inflation-hedging asset classes:

Inflation Hedge #1: Treasury Inflation Protected Securities (TIPS)

Treasury Inflation Protected Securities (TIPS) are government bonds that directly profit from rising inflation as measured by the CPI. With TIPS, both the interest rate and principal value are linked to inflation. If inflation increases 3%, the TIPS principal also increases 3%. When TIPS mature, investors receive either the inflation-adjusted principal or the original principal, whichever is higher.

TIPS provide direct one-for-one protection against inflation (but not deflation). Investors never receive less than their original principal when TIPS mature, and both principal and interest payments increase as inflation rises. TIPS work well when high inflation is expected but offer lower returns than other bonds if inflation remains low. Unlike stocks, TIPS always provide protection against inflation.

While most fixed-income investments perform poorly during high inflation, TIPS are the exception because they directly benefit from rising inflation rates. A typical 10-year bond with a 5% coupon rate loses value during inflation, while TIPS can generate profits in the same environment.

Inflation Hedge #2: Real Estate and REITs

Physical real estate and real estate investment trusts (REITs) typically perform better during inflationary periods.

Residential REITs can profit from higher rents charged to tenants as inflation rises, generating more income for investors. Property values also tend to increase with inflation, particularly when construction costs rise. Real estate owners can generate higher rental income, helping investors keep pace with inflation. This applies to both REITs and physical real estate investments.

REITs don't pay corporate income tax because they distribute 90% of their profits as dividends. However, REIT dividends are taxed as ordinary income rather than qualified dividends, resulting in higher tax rates. Despite this, REIT dividends often increase during inflation.

Related: Real Estate Investing vs. REITs

Farmland

Farmland has proven to be a valuable inflation hedge across various market conditions, with returns consistently outpacing inflation over the long term. This occurs because farmland is both productive and limited in supply, becoming more valuable as agricultural technologies improve.

Farmland investments provide income from rent and/or crop/livestock production, plus potential long-term gains from land appreciation. As this income grows and land values rise, farmland typically outpaces inflation while serving as a stable long-term investment.

Inflation Hedge #3: Commodities

Commodity prices typically rise with inflation, offering protection for commodity investors. This stems from the supply-demand relationship, where increased demand for goods and services can create supply shortages. Higher commodity prices often lead to higher prices for finished goods and services, contributing to inflation.

Investing part of your portfolio in commodities, especially precious metals and energy products, can therefore be wise during inflationary periods.

Gold as an Inflation Hedge

Gold is often recommended during discussions about inflation, but historical data shows it's not a reliable inflation hedge. While gold maintains its value better than currency, its real price fluctuates significantly and doesn't consistently respond to unexpected inflation changes.

There's no inherent connection between gold and changing inflation rates, and the expected returns from gold investments are uncertain. While gold prices and money supply growth show some relationship, no consistent long-term correlation proves gold effectively hedges against inflation.

Gold may maintain purchasing power over very long periods, but it doesn't respond predictably to inflation changes based on historical data. It can serve as a hedge against hyperinflation or economic recession, but investors should consider other assets before relying on gold as an inflation hedge.

Oil and the Crack Spread

The oil industry warrants attention during inflation. Oil refiners buy crude oil and convert it to gasoline or distillate fuel. When refined product prices rise faster than crude oil prices, refiners generate higher profits, potentially benefiting investors in these companies.

The pricing difference between crude oil and refined products appears on a "3:2:1 Crack Spread" chart, showing the profit margin from converting 3 barrels of oil into 2 barrels of gasoline and 1 barrel of distillate fuel. A higher spread indicates greater refinery profits.

Inflation Hedge #4: Stocks

To consistently beat inflation over the long term (i.e., 10+ years), stock investments are necessary. While stocks often perform poorly during short periods of high inflation, their long-term returns have outpaced inflation substantially. The inflation-adjusted return for stocks has averaged 6.82% per year since 1900.

You can calculate the inflation-adjusted return using this formula:

Inflation Adjusted Return = [(1 + Return) / (1 + Inflation Rate)] - 1

Not all stocks provide equal inflation protection. During inflationary periods, focus on companies that maintain pricing power—those able to raise prices without losing customers when their costs increase. A company's performance during inflation largely depends on this ability.

The image below shows which market sectors typically perform best under different combinations of interest rates and inflation:

The U.S. equity market appears in four quadrants, each showing industries that historically outperform based on inflation and interest rate changes:

When interest rates and inflation fall, growth tech stocks, consumer staples, and utilities typically outperform. These are generally the worst stocks during an inflation crisis. Growth tech benefits from cheaper borrowing costs when interest rates fall, while falling inflation generally boosts short-term stock prices.

Consumer staples and utilities have little product differentiation and face heavy competition, giving them minimal pricing power. These businesses operate on tight profit margins, and higher inflation significantly reduces their profitability.

When interest rates fall while inflation rises, real estate, materials, retail, and hardware tech stocks tend to perform better. Real estate particularly benefits from both rising inflation and cheaper mortgages due to lower interest rates.

When interest rates rise while inflation falls, semiconductors and healthcare companies typically benefit most.

When inflation and interest rates rise, financial services companies and commodity producers generally perform best. Financial services companies (banks, credit card companies, insurance providers) earn most of their money from interest, making rising rates particularly profitable when inflation remains manageable. Energy companies and gold miners can also perform well in this environment.

The Bottom Line

Inflation increases the price of goods and services over time, measured by the Consumer Price Index (CPI). As inflation rises, your currency's purchasing power decreases. If inflation outpaces the interest earned on your bank account or investments, you'll experience negative or reduced real returns.

Over long periods, equity investments (including REITs) have significantly outperformed inflation, providing the best long-term protection according to historical data. The best stocks during rising inflation are financial, real estate, and commodity stocks due to their pricing power and relationship with interest rates. The worst performers are utility stocks, consumer staples, and high-growth tech stocks.

For shorter time frames, when the stock market typically falls due to higher inflation, Treasury Inflation Protected Securities (TIPS) may offer the best direct protection.