Best bets for inflation hedges

In an inflationary environment, gold and real estate typically perform well. Will crypto join them this time around?

In a new report, BMO Capital Markets said it expects inflation to prove more durable than initially thought, leading to bigger and faster rate hikes than many expect.

For investors, “this is not a good time for real asset prices in general, but there are some relative safe spots,” it said.

Traditionally, inflation hedges have included commodities, notably precious metals and particularly gold, the report said.

Some argue that crypto can be considered a form of “digital gold, which might make it a modern-era substitute,” the report noted.

However, at this point, cryptos “have a limited track record as inflation hedges, and could well sell off alongside other assets if interest rates rise too much.”

Other possible safe havens include equities, the report said, noting that the asset class has been able to “scratch out more neutral real returns, acting as an insulator against upward price pressure.”

In particular, Canadian equities have “outperformed somewhat in inflationary environments,” the report said, given a higher concentration to the resource sectors and relatively low exposure to growth-oriented stocks “that would see valuations cut deeper in such an environment.”

Dividends are also important in terms of generating real total returns amid overall inflation, the report said.

Stock picking may become more important too.

To that end, the report recommended favouring companies with pricing power that can pass along cost increases to their customers.

“Firms that face limited competition and sell items with inelastic demand (due to a lack of close substitutes) are likely to preserve capital during periods of rising inflation,” it said. “By contrast, firms with limited pricing power are often forced to absorb higher costs in earnings. Canada has many names with a rich history of dividend increases that fit the bill.”

Diversification is another consideration, given that inflation isn’t a worldwide phenomenon.

BMO pointed to Japan as a market that isn’t facing any inflation at this point.

“While its economy would still suffer as a global downturn slams exports, it would stand a better chance, than nations with high inflation, of avoiding a recession given low interest rates,” it said.

Alongside certain equities, BMO noted that real estate has generally managed to post positive returns in past inflationary periods too.

This time around, however, housing markets have been so hot that they represent a risk.

“Real estate prices could be tested given the dramatic increase in valuations during the pandemic, especially in Canada,” the report said. “Commercial real estate looks less inflated at this point, and should hold up reasonably well with underlying economic conditions still strong, though the office sector faces longer-term challenges from remote working.”

Fixed-income options include inflation-protected notes and money markets, which currently have tiny returns.

“Moving funds into debt securities with rising payouts and short maturities, or rate-reset preferred shares, also provides flexibility to eventually lock in at higher rates when inflation and interest rates peak, or shift to equities. These lower-duration products have largely preserved capital in the past,” it said.

It’s also a good time for borrowers to lock in low rates, if possible.