Inflation makes the front page of many of today’s newspaper headlines in the UK — and not just the FT. Why? Because the Bank of England’s new chief economist is warning that high levels of UK inflation could persist for longer than expected. In a document submitted to the Treasury Select Committee, Huw Pill said: “In my view, (the) balance of risks is currently shifting towards great concerns about the inflation outlook, as the current strength of inflation looks set to prove more long-lasting than originally anticipated.” If Mr Pill’s assessment is correct, what does it mean for investors” And what is the best way to hedge against inflation? LARRY SWEDROE assesses the latest evidence.
While inflation has not been a serious or persistent economic problem in developed markets for decades, the unprecedented increase in money creation and extraordinary expansionary fiscal spending around the globe has led to heightened concerns about inflation risks. For example, the U.S. money supply (M2) has grown by $4.9 trillion, from $15.5 trillion to $20.4 trillion in the 16 months between February 2020 and June 2021; and the Congressional Budget Office (CBO) estimates a U.S. fiscal deficit of $3.1 trillion in 2020, or 14.9 percent of gross domestic product (GDP). The CBO forecasts the deficit will be slightly reduced to $3.0 trillion in 2021, or 13.4 percent of GDP. In the entire modern history of the United States, there have only been two instances of consecutive double-digit deficit years.
To help address the concerns, Henry Neville, Teun Draaisma, Ben Funnell, Campbell Harvey and Otto Van Hemert, authors of the study The Best Strategies for Inflationary Times, which appears in the August 2021 issue of The Journal of Portfolio Management, analysed the performance of a variety of asset classes for the United States, the United Kingdom and Japan since 1926 to determine which have historically tended to do well (or poorly) in environments when year-over-year (YoY) inflation was accelerating and when the level moved to 5 percent or more. They defined the regime end as the point at which the YoY Consumer Price Index reached its peak without having fallen below 50 percent of its maximum annual rate in rolling 24-month observation windows. They observed a total of 34 inflationary regimes across the three markets, eight of which occurred in the U.S.: 4/41-5/42, 3/46-3/47, 8/50-2/51, 2/66-1/70, 7/72-12/74, 2/77-3/80, 2/87-11/90 and 9/07-7/08. Following is a summary of their findings for the U.S.:
- Both nominal bonds (the 10-year Treasury lost 5 percent per annum in real terms) and equities (averaged -7 percent real return and was negative in 75 percent of the periods) tended to do poorly. Consequently, the 60/40 equity/bond portfolio performed poorly during high inflationary regimes, with a -6 percent real annualized return.
- No individual equity sector offered significant protection against high and rising inflation—even the energy sector was only slightly better than flat in real terms. Weak sectors included those with a high exposure to the individual consumer, such as durables (-15 percent) and retail (-9 percent). Technology was also weak, at -9 percent. Financials were weak (-9 percent) because default risk dominated the benefits of possibly rising rates and because there can be a lag between an inflationary regime and central bank tightening.
- Both high yield (HY) and investment grade (IG) lost an annualized 7 percent in real terms during high inflationary regimes—hedging IG and HY long positions with short government bond positions of similar duration did not provide inflation protection.
- Treasury inflation-protected securities (TIPS) returns have been robust when inflation rises—they provided similar positive real returns in inflationary and noninflationary regimes (today, TIPS yields are negative across the curve).
- Commodities provided the best historical performance, showing much higher real returns during rising inflationary environments—averaging an annualized 14 percent real return. In all other periods, the real return averaged 1 percent annually. Energy provided the highest real return (41 percent annualized), while gold and silver returned 13 and 12 percent annualized, respectively.
- Residential real estate underperformed during high inflationary regimes, losing 2 percent annually in real terms. It gained 2 percent annually during all other periods.
- Collectibles, such as art (7 percent), wine (5 percent) and stamps (9 percent), provided strong real returns during inflationary periods (although weaker than commodities). In all other periods, the real annualized returns were 2 percent, 6 percent and 3 percent, respectively.
- Among equity factors, cross-sectional stock momentum was the best performer during inflationary regimes, realising an 8 percent annualized real return versus 4 percent in normal times. However, the difference was not statistically significant for this volatile, high-turnover strategy. The quality and investment factors also performed well during inflationary regimes, returning 3 percent and 2 percent annualized, respectively, in all regimes.
- Equity factors with negative real annualized returns during high inflationary regimes included profitability (-1 percent), value (-1 percent), low volatility (-3 percent) and size (-4 percent). Keep in mind that low beta stocks tend to be more bond-like, and thus their poor performance is not surprising.
- The time-series momentum (trend-following) strategy performed well during inflationary regimes, with the bond and commodity trend doing particularly well, as inflation shocks do not tend to be overnight affairs but rather prolonged episodes that play to the strength of trend strategies.
Neville, Draaisma, Funnell, Harvey and Van Hemert found similar results for both the U.K. and Japanese markets. Of particular interest, they found that equities tended to perform worst during their own country’s inflationary periods. For example, U.S. equities achieved 6 percent and 9 percent real annualized returns in U.K. and Japanese inflationary periods compared to -7% in U.S. regimes. Taking the U.K. perspective, U.S. and Japanese equities generated 6 percent and 9 percent real annualized returns, respectively, during U.K. inflationary regimes. For investors looking to hedge against inflation, this suggests benefits to international diversification.
Equities don’t hedge against inflation
Neville, Draaisma, Funnell, Harvey and Van Hemert noted that while investors may believe equities provide some protection from inflation (a firm’s debt obligations are inflated away, and product prices may be adjusted to inflation), equities tend to suffer from the less stable economic climate (the rate at which future earnings are discounted rises), and costs tend to rise with inflation more than output prices. They also noted that despite the poor performance of equities in high and rising inflationary regimes, equities actually benefited from rising inflation when the starting level was below the median (when there was risk of deflation) but were hurt by rising inflation if the starting level was above the median (when there was increased risk of escalating inflation).
The authors concluded with this note of caution: “Even if one forecasts a rate of inflation in the 2%–3% range over the next few years, it is likely that that forecast has a larger confidence interval than the same forecast at the end of 2019. Given the unprecedented monetary and fiscal interventions, most agree that inflation risk has increased. As such, it is time that portfolio managers review their asset positioning in the face of this heightened risk.”
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LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
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