Good luck hedging against inflation

February 3, 2011

Looking to hedge against a spike in inflation? Equities may not be much help.

Neither, for that matter, will you do all that well over the longer haul with bonds, cash or even commodities, at least on the historical evidence. In short, when it comes to investing, inflation is a real drag.

It’s impossible to know if, much less when, the current very stimulative monetary policy in the developed world will spur inflation, but increasingly indicators are raising concerns. Emerging market economies show signs of overheating, while prices of food and many other commodities are surging.

The traditional view has been that equities are an effective hedge against inflation, in least over the long term, because companies will, all things being equal, eventually pass on inflation to their clients as higher prices.

That’s the theory, but the practice may prove to be much different, according to a study by IMF economists Alexander Attie and Shaun Roache, who examined the performance of a range of traditional asset classes in the aftermath of inflation shocks.

“Among traditional asset classes, inflation hedges are imperfect at best and unlikely to work at worst,” according to Attie and Roache.

First, the authors looked at returns in the 12 months after inflation shocks in the period after the 1973 end of the Bretton Woods system of fixed currencies. The results were not surprising; bonds got killed, equities did badly, as did cash, while commodities were an effective hedge. Real estate investment trusts (REITs) did about as badly as equities, somewhat undermining the argument for real estate during inflationary periods.

All well and good, but really only of use for the small number of daredevils who are willing to make big asset allocation shifts over a short period of time.

For most savers, not to mention pension funds and endowments, the more useful question is how do you hedge against inflation for the longer term?

The results for equities were not encouraging.

“Equity returns decline in the months following an inflation shock and do not experience a meaningful recovery thereafter, leaving them as the worst performing asset class in our sample,” according to the study.

“Our findings are consistent with evidence from a range of earlier studies and add further weight to the evidence against the theoretical arguments for equities as a real asset class providing inflation protection when inflation is rising.”

Over the 18 months after the shock, real returns were negative, though less negative than bonds, which get hammered by inflation. Equities improve a bit over the next couple of years, but even when looked at in the long run of more than five years an inflation shock makes for losses in real terms.

As for the other asset prices, inflation proves very difficult to hedge against even over the longer term. Take commodities, the star performer in the first 18 months after inflation bites; spot prices decline in the medium term and when you get above five years after the inflationary event you are looking at actual losses in spot prices. This might be because inflation hits demand, but also might be because high prices spur greater investment in efficiency, which over the long term also moderates demand.

While bonds get killed in the first couple of years after an inflation shock, after about three years returns improve, presumably partly because investors demand higher yields to make up for nasty recent experiences.

Cash returns do a bit better, but even cash, which can go where it likes in search of better returns as inflation increases, fails to serve as a perfect hedge over the longer term.

So, how to hedge against inflation? Inflation-protected bonds such as TIPS would work, but to be a hedge you have to buy and hold to maturity, as outside forces can easily distort returns through the life of a given bond.

Given that inflation is a portfolio killer, why then are equity markets booming? Well, in emerging markets where inflation is kicking in first they are not. In developed markets, investors seem to be placing a touching amount of faith in central bankers. After all, if the Federal Reserve and ECB don’t pull the plug on stimulus in time, inflation can easily get out of control.

Or perhaps equity markets are betting the central banks will fail to stoke growth and be forced to blow a larger asset market bubble as a consequence.

Or maybe everybody thinks they will be the genius who gets out in time.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. email:


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Not a very good article without even a mention of gold or silver.

Posted by billwonkers | Report as abusive

The U.S. has never in its history had as much fiscal and monetary stimulus, yet look where we are. Large caps and techs with big exposure to Asia have spectacular earnings, luxury retailers doing well, and the rest of the economy is still in the doldrums. We have NOT solved any of the over-leveraging problems, only deferred the pain. The Fed, not satisfied that they were unable to fulfill the 2 mandates given them by Congress, now takes on a 3rd mandate: reducing unemployment. They completely ignore the fact that 4-6 % of our unemployment is now structural, not cyclical. Continuing this pursuit of a triple mandate can only lead to hyperinflation.

Posted by martinm7703 | Report as abusive

We can’t afford inflation for long so I have few worries mate! I worry more about the decade of deflation we face and the moral consequences of monster government spending!

Posted by DrJJJJ | Report as abusive

This would be more useful if “equities” were further classified. It would seem logical that certain sectors would perform far better than others–at least on a relative basis. Further, the [straw man] examples smack of buy and hold, which is not realistic for any informed investor, and certainly not for a trader. There is NO PLACE TO HIDE? Doubtful. Being nimble must be the best option. Finally, there are always some stodcks that simply grow for extended periods of time (e.g., Microsoft, Apple, TNH)–I find it inconceivable that there is no solution. I concur however that there may not be any easy solution–no solution that the average money manager can effect.

Posted by Rickenbacker108 | Report as abusive

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talking about “stocks” as an asset class is fun and very interesting but an easy way to see that these experts from the IMF are still the same old jokesters they ever were. not once in my 50 years of actively managing my savings did I put ANY money into a stock index fund, let alone a big cap index fund, as the IMF suggests. Cash is an asset class, bonds maybe and big cap index funds, okay maybe. But to most of us the word “stocks”, just as with our own businesses or professions we individually choose, have specific customers and products in mind and we are anything but passive in them. trying to play the entire market, like trying to appeal to everyone, is a losing proposition. we don’t need a study to tell us that.

Posted by threeRivers | Report as abusive

The FED in order to fight future inflation expectations will need soon to tighten interest rates and drain liquidity from the system.
The FED should act carefully because by raising interest rates it risks to choke any hope of recovery of the real estate market.
To avoid this happening it should only raise short-term interest rates while leaving the long ones unchanged.
To do so the FED has few tools at its disposal such as to raise the interest it pays to banks for excess reserves, to drain liquidity from the banking system through reverse repurchase agreements ( reverse repos ) and conducting term deposit facility auctions so to reduce the supply of funds that banks lend to each others. Finally it could reinvest the proceeds from maturing longer-term Treasuries, now in its balance sheet, into shorter-term Treasuries.
Regarding instead the long- terms interest rates, the FED should initiate another round of QE and buy 30 ys Treasuries until the end of 2012 so to keep their yields more or less at the today’s level.
To combine this it will not be easy and it will require a fine balancing act by the FED.

Posted by CiucciNeri | Report as abusive