“I grew up within the Seventies and studied economics, and I still keep in mind that terrible time. … Nobody wants that to occur again.” – Janet Yellen
introduction
Inflation has dominated investor conversations in 2021. Many countries have recovered well from the Covid-19 crisis and are experiencing significantly higher inflation than expected. The annual inflation rate within the United States rose to five% in May 2021the very best level since August 2008.
Inflation is a continuing concern for investors, however it has grow to be much more vital since central banks introduced their aggressive monetary policies through the global financial crisis. Although inflation has been declining for the reason that Nineteen Eighties, the cash printing has alarmed inflation hawks. Some are even warning of possible hyperinflation paying homage to the Weimar Republic within the Nineteen Twenties.
Investor Survey 2021: What is the perfect option to hedge against inflation?
Regardless of whether the present higher levels are temporary or structural, how can investors hedge against inflation risk? According to a recent survey of quantitative investors at a JPMorgan conference, 47% of respondents consider that commodities are probably the most effective hedge against inflation, followed by equities (27%), rate of interest products and US Treasury Inflation-Protected Securities (TIPS, 10%), and other instruments (17%).
For commodities corresponding to precious metals, the situation is obvious. For stocks, that is less true: since corporations can raise their prices at will, the idea goes, they’ll mitigate the negative effects of high inflation by simply raising their prices accordingly.
Does the information support this argument? Are stocks a hedge against inflation?
A glance back at US inflation
The average annual inflation rate within the United States between 1947 and 2021 was 3.4%. It was below 0% only about 15% of the time and above 10% only 7% of the time. It was between 0% and 5% 57% of the time and between 5% and 10% about 20% of the time.
Most investors in today’s developed markets know high inflation only from history. Although it is usually discussed, few traders have experienced firsthand the devastating impact it could possibly have on economies and financial markets.
Annual inflation within the USA
Stock returns in several inflation regimes
We created 4 inflation regimes for the period from 1947 to 2021, based on inflation data from the St. Louis Federal Reserve and stock market data from the Kenneth R. French Data Library.
Average monthly stock returns were comparable across these different environments. The lowest returns occurred in periods of deflation, which generally accompany economic recessions. However, inflation above 10% didn’t appear to have a negative impact on stock market returns.
Monthly US stock returns by inflation regime, 1947 to 2021
Real vs. nominal returns
Of course, it is an easy but common mistake to investigate returns without taking inflation into consideration. A savings account with an rate of interest of two% is kind of attractive when inflation is 0%, but not a lot when inflation is at 3% and means a negative real rate of interest.
Comparing nominal and real monthly equity returns across the 4 inflation regimes provides a really different perspective. In real terms, inflation above 5% sharply reduced returns, while inflation above 10% essentially made equities unattractive.
Perhaps the true return remains to be positive and due to this fact equities have indeed served as a hedge against inflation. However, equities are volatile instruments and the common return masks the dramatic losses which have occurred over the 70 years in query.
Monthly real returns of US stocks by inflation regime, 1947 to 2021
Inflation losers
So which industries have suffered probably the most in periods of inflation? Our evaluation of the 30 industries covered by the Kenneth R. French Data Library found that when inflation exceeded 10%, the industries most affected were those who dealt directly with consumers – consumer goods, autos, retail, etc. Although these corporations can adjust their prices at will, they appear to have difficulty passing the increases on to their customers.
A recent example of that is the European financial industry. Banks were reluctant to charge negative interest on retail savings accounts, but still charged negative interest on the deposits of asset managers and other institutional clients.
Monthly real returns on US stocks: The 10 worst sectors in high inflation, 1947-2021
Winners of inflation
When inflation was between 5 and 10 percent, the identical sectors didn’t consistently underperform. Some even produced positive returns. In contrast, the sectors that benefited most from high inflation benefited almost identically through the two periods of upper inflation: particularly, energy and commodities, which investors often depend on when positioning their equity portfolios for higher inflation.
Monthly real returns on US stocks: The 10 best sectors in high inflation, 1947 to 2021
While this confirms the inflation-hedging properties of the same old suspects, there are caveats. The two periods of hyperinflation occurred mainly within the Seventies, when US inflation reached 23.6%. Inflation was influenced by an increase in oil prices as a consequence of an OPEC embargo. The price of WTI crude oil rose from $4 per barrel in 1973 to over $10 in 1974, after which rose to $40 in 1980.
Volatility in oil prices is prone to proceed amid geopolitical unrest, and in theory prices could rise to latest highs. But the world is reducing its reliance on fossil fuels, and the U.S. fracking industry has helped increase supply. While the energy sector has been an excellent bet against inflation prior to now, that trend may not proceed in the longer term.
So what happens if we exclude the oil price boom-and-bust cycle and the period 1973-1986 from our evaluation? The same ten sectors still perform well in a high inflation environment that isn’t brought on by oil prices.
Real monthly US stock returns: The 10 best sectors excluding the oil crisis from 1973 to 1986
Further considerations
Although some stock sectors have inflation-hedge characteristics, this data has little practical value. To be useful, it might require skills in properly timing the market. Moreover, such stocks are commodity proxies, so even when investors could predict inflation, they might probably be higher off investing directly in commodities.
And the arguments for holding commodities are flimsy. The Goldman Sachs Commodity Index (GSCI) is trading at concerning the same level today because it was in 1990. Such a position can be unsustainable for many investors. A bet on commodities is a bet against human progress: in the long term, it’s prone to be a losing proposition.
A more interesting inflation hedge could be investing in trend-following commodity-focused funds or Commodity Trading Advisors (CTAs). If oil or gold prices rise as a consequence of higher inflation, these funds will ultimately jump on the trend. If prices fall as inflation falls, investors can short these asset classes. Of course, this strategy won’t at all times work perfectly – the last decade is a stark reminder of that – however it could be a more elegant option to hedge against each inflation and deflation.
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