Inflation and ETFs

• Level: For advanced
• Reading duration: 4 minutes

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 annual inflation is 3% that means a representative basket of goods and services bought by UK households is 3% 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:

The UK’s CPIH basket of goods and services

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

• For example, e-bikes, security cameras, and frozen berries were introduced for the first time in 2023. Meanwhile, digital compact cameras and spirit-based drinks  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. This time around, rapidly rising food and energy have contributed to a cost-of-living crisis that’s disproportionately affected the poorest households. That’s because it’s difficult to cut back upon or substitute everyday essential items for cheaper goods. Moreover, the most vulnerable sections of society are the most likely to have a high percentage of their budget consumed by the basics.

An uncertain outlook

Currently, inflation is easing off since hitting a thirty year high in 2022.  But despite its rapid series of interest rate hikes, the Bank of England isn’t predicting a return to normality for inflation until 2025. Meanwhile, prices are still rising, the economy is in the doldrums, and growth forecasts are being cut again. Several factors point towards a period of stickier  inflation than was common pre-COVID. Heightened geopolitical tensions - from the war in Ukraine to conflict in the Middle East to ongoing mistrust between the US and China – contribute to the uncertainty. In particular, the last trend has prompted moves to derisk and re-shore supply chains that are likely to generate longer term price inefficiencies. The good news is that rising pay has not so far super-charged inflation and created the vicious spiral of soaring prices and wage settlements that scarred the 1970s.

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 in 2009, it would have needed to grow to £15,250 to maintain its purchasing power today. But a cash instrument like a money market fund only grew to £10,825 in that time. Yet if you’d invested your £10,000 in an MSCI World ETF in 2009 then it would now be worth £44,580! The reality is most people have lost money on cash . Meanwhile, equities have comfortably outpaced inflation and cash, on average, for more than one hundred years. 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.

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

• Equity strategies: Shares in companies that can pass on rising prices to their customers may be more resilient against high inflation. For instance, consumers must always buy essentials like food and electricity. They’ll drop discretionary items first if their purchasing power is threatened. Investors can anticipate these pressures by buying ETFs from sectors such as consumer staples and utilities. Companies with a defendable moat are also well-positioned to resist inflation. Think market-leading tech companies.
• Commodity strategies: Commodity investments can be a good hedge as raw materials tend to be an underlying driver of inflation. For example, oil and gas commodities rose steeply during the inflationary oil shock of the early 1970s, and once again as prices surged in 2021 to 2022.
• Inflation-linked bonds: These government bonds are specifically designed to pay interest at the headline inflation rate plus a little extra. UK inflation-resistant bonds are called index-linked gilts. You can buy them in ETF form and versions including global bonds are available too.
• Cash and short-dated bonds: Money market ETFs and short-term bonds cope reasonably well with moderate inflation. That’s because you can quickly reinvest at higher yields as interest rates rise.
• Gold: The precious metal is a commodity and a store of value with a restricted supply. That means it typically performs during economic shocks when people fear currency debasement. Those unusual characteristics meant gold did extraordinarily well during the stagflationary 1970s, the Great Recession, (when some featured QE would spark hyperinflation) and once again during the recent inflationary crisis.

Short-term inflation-linked bonds are a good hedge against prolonged periods of elevated inflation. However, they can be hurt if interest rates rise extremely quickly - which is exactly what happened in 2022. 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 is liable torocket. Overpaying for an 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?