There are investing strategies that can protect your portfolio from inflation, but it's important to keep a long-term perspective.

The latest Consumer Price Index (CPI) monthly indicator, released at the start of March, provided some scope for optimism that inflation may have peaked.

The inflation indicator showed a 7.4 per cent increase over the year to 31 January 2023. While still high, this was down from the 8.4 per cent annual rise recorded in the previous month.

It was an early sign, although in economic terms it’s still too early to identify it as a definite turning point.

So, we expect the Reserve Bank will again raise rates in April because it will want to see more solid evidence that inflation is on a downward trend towards its 2-3 per cent target range.

By May – a full 12 months after it began raising rates – we believe the central bank will be more confident that inflation is falling and will keep rates on hold as they pause to assess the impact of earlier rate hikes.

We expect Australia’s headline inflation rate to likely fall to around 4.25 per cent by year-end, and price rises to fall back to the RBA’s target band in 2024.

Threats to lower inflation

The near-term threats to getting inflation levels down quickly remain low unemployment and continued wages growth.

Australia’s seasonally adjusted unemployment rate fell to 3.5 per cent in February, reversing the fall in new job starts in January.

The seasonally adjusted Wage Price Index released by the Australian Bureau of Statistics also showed there was a 0.8 per cent increase in wages and salaries in the December quarter 2022, and 3.3 per cent annually, which added to the rises recorded in the June and September quarters.

In terms of key risks, we are most concerned about the risk of higher wage growth triggering a wage inflation spiral, which would keep inflation higher for longer.

Meanwhile, global financial markets, outside of a plethora of other events destabilising investor sentiment, remain fixated on the impact of high inflation and interest rates on economic growth.

Protection from inflationary shocks

Following the sell-off in most major asset classes in 2022, investors may now be questioning what levers are available to protect their portfolios from further inflationary shocks. Unfortunately, there is not a clear-cut answer, rather a range of trade-offs that ultimately depend on each individual’s investment goals, time horizon, and risk tolerance.

Even so, cash and commodities have garnered interest among investors, as inflation remains elevated and as cash rates continue to rise. Those considering tilts to either asset class should consider the various trade-offs in play before making any adjustments to their portfolio allocations.

For instance, cash is often perceived as a low risk and safe investment for short holding periods but over the longer term, holding a large allocation to cash risks erosion of purchasing power to inflation, whilst forgoing opportunities for growth in equities and other asset classes.

By contrast, the performance of commodities is often linked to inflation, with commodities typically performing well in periods of unexpected inflation. However, they have historically underperformed other assets outside of these time periods, producing a negative return of -1.7 per cent over the past 20 years compared to a positive 8.3 per cent for global equities, and having an 80 per cent higher volatility. Therefore, in order to realise the full benefit of holding commodities as an inflation hedge, investors have to correctly time their entry into and out of their position, which is very difficult to do.

Equities can also provide a hedge against inflation through capital appreciation. As the price of goods and services rises, the value of companies with strong pricing power and competitive advantages can also increase. Unlike commodities, which provide short-term inflation protection, equities have historically provided the best chance of beating inflation over the long run, and have ultimately outperformed other asset classes.

Keep a long-term perspective

As always, when it comes to considering any portfolio changes, investors should keep in mind that markets are forward looking and generally good at incorporating information. In other words, market prices likely already reflect expectations for the future direction of inflation and economic growth.

For an investor’s view to pay off, it not only must be high conviction but sufficiently different from market expectations. Sell-offs in major asset classes over 2022, although painful, mean that markets have already incorporated much of the impacts of sharp policy tightening that have been required to tame inflation.

There may be many reasons for investors to be contemplating short-term inflation hedges for their portfolios, but longer-term investment goals and plans should always guide decisions rather than short-term volatility.

This article was also published in The Australian Financial Review.