Inflation hedging has become a hot topic among investors, especially in light of recent consumer price inflation numbers that indicate a faster and higher rise in inflation than any time since the global financial crisis over a decade ago. This article aims to address key questions related to inflation hedging and strategic asset allocation.
1. Does inflation only matter to investors with liabilities denominated in real dollars?
Not necessarily. High inflation periods can be detrimental on a nominal basis as well, especially when the cash return is zero.
2. Is gold an effective option for investors who want to hedge inflation?
Historical evidence suggests that gold may not be a reliable inflation hedge. Broad commodity investing approaches are more likely to yield positive results. Relying solely on precious metals to hedge inflation could lead to disappointment.
3. How can we build a strategic asset allocation that accommodates multiple inflation scenarios?
One method is to adjust historical means of asset returns and inflation to reflect forward-looking investment views, then build optimal portfolios based on the new distribution of asset and macro data. The current low expected return on bonds makes the opportunity cost of owning inflation-sensitive assets much lower than it has been historically, increasing the optimal exposure to these assets across multiple portfolio objectives.
Historically, both stocks and bonds have generated a negative real return during most inflation episodes, underperforming cash in these environments. This makes inflation hedging an important concept, even for investors with objectives denominated in nominal terms.
Broad commodities have generally performed better than gold during inflationary episodes. Gold was particularly helpful during the inflation episodes in the 1970s. Treasury Inflation-Protected Securities (TIPS) were good at hedging their own cash flows against inflationary pressures and outperformed cash on a real basis, but the outperformance was not substantial enough to hedge a broader portfolio against inflationary shocks.
Gold's performance during inflationary episodes was strong in the 1970s but has been much less related to inflation since then. The conditions that made gold work so well in the 1970s are simply not present today.
Broad commodities, on the other hand, have had a much more reliable relationship to inflation throughout history. However, they have generated low or even negative returns over the last three-plus decades, a period during which the US has experienced very little inflation.
Standard portfolio construction concepts and some first principles of commodity futures markets can be used to design a structurally superior commodity strategy. This strategy has the potential to generate returns in the neighborhood of cash plus 3% in a benign inflation environment, with expected returns that scale at over three-to-one relative to inflation, and an expected nominal return of cash plus 30% if inflation hits 10%.
Historical Market Performance during Inflation Episodes
Traditional stock and bond investments typically perform poorly during inflation episodes, particularly on a real (net of inflation) basis. Some typical inflation-hedging assets include TIPS, gold, and broad commodities.
Inflation Asset Performance during Inflation Episodes
TIPS may effectively hedge their own cash flows, but they do not generate enough additional return during inflation episodes to consider them a hedge for a broader portfolio. Gold performed very well during the inflation episodes in the 1970s but had virtually no relationship to inflation after 1980. Broad commodity prices, on the other hand, rose more than one-for-one with inflation in every inflation episode for which we have data.
Unpacking the Great Gold Performance of the 1970s
The great inflation of the 1970s was immediately preceded by the final abandonment of the gold standard.
During this period, gold prices rallied dramatically relative to the US dollar. This was not an endogenous macroeconomic response to inflation—it was the direct result of the same event that drove a portion of the inflation. The conditions for a repeat of this performance are not in place today.
Commodity markets have certain empirical features that can be leveraged to design a strategic inflation hedge. These include low correlation to one another, relatively low return, high volatility, and a substantial cost of carry, particularly in near-dated commodity futures.
A diversified commodity portfolio can significantly reduce volatility, boosting geometric expected return. The risk reduction facilitated by diversification dampens the risk of a portfolio of commodities and boosts geometric expected return.
Commodity markets also embed a cost of carry, often called a “convenience yield.” This can be understood through the lens of zero-arbitrage conditions, which are the series of physical market-replicating transactions.
Inflation hedging is a complex issue that requires careful consideration of various asset classes and their performance during different inflation scenarios. While gold has traditionally been viewed as an effective inflation hedge, its performance is not consistent across all inflationary periods. Broad commodities, on the other hand, have shown a more reliable relationship with inflation.
Strategic asset allocation that accommodates multiple inflation scenarios can be achieved by adjusting historical means of asset returns and inflation to reflect forward-looking investment views. This approach can help investors navigate the complexities of inflation hedging and make more informed investment decisions.
