Investing Basics: Inflation and ETFs

Learn how ETFs can protect against inflation and which strategies best combat rising prices – by Jan Altmann

 
Inflation is like capitalism caffeine. A small amount gives the economy a boost but too much causes major headaches and even outright dysfunction.

Official inflation measures are designed to track the rise and fall of prices over time. If inflation is 2% that means a representative basket of goods and services bought by UK households is 2% more expensive than at the same time last year – on average.

If our incomes are static then inflation erodes our purchasing power. Economists sometimes define savings as “delayed consumption”. High inflation means that our savings will buy less in the future than they do today – unless our accumulated wealth can keep pace with inflation.

But it’s been a long time since savings accounts matched inflation. Cash in the bank has typically earned a negative interest rate for well over a decade – after deducting inflation.

That’s where ETFs come in. Canny purchase of inflation-hedging investments can offset or even beat inflation over time.
 

How inflation is tracked

 
The headline measure of inflation mentioned in news bulletins works by tracking the price changes that affect the so-called ‘basket of goods’.

This snapshot of British spending habits is supposed to show what we spend our money on: including housing, electricity, petrol and mobile phone contracts.

You can check the exact composition of the basket of goods as published by the Office for National Statistics (ONS). The broad spending categories for the Consumer Prices Index including owner occupiers’ housing costs (CPIH) break down as follows:
 

 
Of course, the shopping basket is only a picture of ‘average’ consumer spending. The ONS constructs CPIH by sampling ​​the prices of around 700 items they believe represent typical consumer spending. They update the basket over time to keep it on trend.

For example, electric cars, hand gel, and smartwatches were introduced for the first time in 2021. Meanwhile, staff restaurant sandwiches and gold chains dropped out.

Your actual rate of inflation will differ insofar as your spending doesn’t match the basket.

You may not smoke, or eat meat, or have a pet. You may spend more on coffee and less on tea than assumed by the ONS.

Your gender, region, brand preferences and frequency of purchase are just some of the factors that will affect your personal experience of inflation.

For example, high-mileage drivers will be highly sensitive to petrol price increases. But the rising price of steak may not worry you if you’re happy to substitute it for chicken.
 

Why inflation is dangerous

 
How much inflation is healthy and how much harms our standard of living? The UK Government sets an inflation target of 2% for the Bank Of England. That’s because low-level inflation is thought to be good for the economy.

Deflation, on the other hand, damages economic output as people delay spending in anticipation of falling prices in the future.

Very high inflation can cripple an entire economy though as staple items become unaffordable. Zimbabwe, for example, has been repeatedly ravaged by hyperinflation.

Currently, inflation is a major concern but the outlook remains highly unpredictable.

Whereas central banks were fighting deflation only a few years ago, spiralling inflation is back on the agenda.

Several factors point towards higher inflation. Most developed countries staved off recession during the pandemic by expanding their balance sheets by trillions of pounds, dollars, euros and yen.

Meanwhile, interest rates were cut to historic lows.

As COVID becomes endemic, the global economy has struggled to adjust to rolling supply and demand shocks caused by successive waves of COVID restriction and relaxation.

The question is whether these unprecedented conditions will unleash inflation.

The last time the developed world faced runaway inflation was back in the 1970s. High prices followed by high wage settlements stoked a vicious combination of rising prices and low economic growth known as stagflation.

Central banks can combat spiralling inflation by raising interest rates. But they may not act quickly enough for fear of provoking a recession and driving national debt burdens to unsustainable levels.
 

How ETFs can protect against inflation

 
Cash has historically barely beaten inflation. It’s also been a losing asset for over a decade.

If you had £10,000 saved 10 years ago, it would have needed to grow to £13,112 to maintain its purchasing power today. That meant earning an average annual interest rate of 2.7% to keep pace with inflation.

Yet if you’d invested your £10,000 in an MSCI World ETF in 2011 then it would now be worth £29,632!

The reality is most people have lost money on cash for the last 10 years. Meanwhile, equities have comfortably outpaced inflation and cash, on average, since the beginning of the 20th Century.

MSCI World ETFs enable you to buy a diversified portfolio of equities simply and inexpensively. Historically, this has proven to be an excellent countermeasure to inflation.
 
justETF tip:ETFs for beginners page is the perfect place to start your investing journey.
 

The best ETF inflation hedges

 
There’s more than one way to protect yourself against inflation and diversify your portfolio at the same time.

Different strategies can defend your wealth against different types and severities of inflation.

For example
 

 
Inflation-linked bonds are the best hedge for immediate defence against spiralling inflation.

Diversified equity holdings (such as the MSCI World) can do well in moderate inflationary scenarios and outpace inflation in the long-term as we’ve seen. However, they aren’t a fix against runaway inflation in the short term.

If you’re expecting an energy crisis then energy sector commodities could be a good hedge. You can also invest in broad commodity indices if you wish to spread your bets across all raw material categories.

Gold has a tendency to work when other assets retreat so it can be thought of as the ultimate diversification optimiser.

A golden rule of investing though is that you must be positioned in each asset class before its price is bid up by other market participants. For example, if everyone believes that stagflation is a near-certainty then demand for inflation-linked bonds will rocket. Overpaying for investment can expose you to future losses when the crisis passes or fails to materialise and demand falls. Such losses can nullify the value of inflation protection.

 
In the short term, you can lose money on any investment. However, you’ll reap the reward if you ride out temporary losses and stay invested for the long term. The phenomenon of mean reversion describes how investors tend to overreact to crises and sell too soon. If you can resist this urge then your investments should bounce back and boost your wealth over time.

The buy-and-hold strategy epitomises this long-term investing wisdom which is why it regularly beats more short-termist strategies.

Ultimately, the key is to diversify your portfolio across the major asset classes. That maximises your chances of being pre-positioned in the best-performing asset class regardless of the economic conditions.

This approach will enable you to take advantage of future growth opportunities and ensure your wealth is protected against looming threats such as inflation.

The easiest way to implement this strategy is with an ETF savings plan. Discover the best ETFs for your savings plan in our ETF savings plan comparison.
 
Find out more about globally diversified ETFs in our investment guides:
Developed market ETFs: Which is the best?
World ETFs: Which is the best?
 

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