Good luck hedging against inflation
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.
IN THE LONG RUN WE’RE ALL …
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: firstname.lastname@example.org)