Some investors are worried that inflation is set to rise. We look at which assets are likely to offer the best protection.
In the wake of Covid-19, investors have started debating whether long-dormant inflation risks will soon resurface.
Stay-at-home orders and government spending have left consumers with extra savings and pent-up demand that could eventually drive a spending splurge.
At the same time, lockdowns have kept many businesses shut, destroying capacity in some
sectors of the economy and fracturing parts of the supply chain. If demand rises faster than the recovery in supply, we could see prices rebound.
Markets are slowly waking up to this possibility. Inflation expectations, as measured by the yield difference between nominal and inflation-protected US Treasury bonds, have bounced back sharply from their pandemic lows. They are now just above their average of 2% seen for the past decade.
Investors should not underestimate the pernicious effect that inflation can have on the value of their wealth. Rapid price increases lower a currency’s purchasing power, reducing the amount of goods and services you can buy with money.
This damage can be mitigated by investing, although your capital is at risk and different asset classes will offer varying levels of inflation protection. Traditional portfolios, such as those holding equities and bonds, are potentially most exposed.
How would rising inflation affect markets?
Inflation can be good for holders of assets, if their values rise faster than the general level of inflation. However, it can be bad for anyone with a fixed income.
Bonds are therefore an obvious casualty. Their fixed stream of interest payments become less valuable as the overall cost of goods and services accelerates, sending yields higher and bond prices lower to compensate.
Short-dated Treasury bills (T-Bills) are unlikely to yield better results. The US Federal Reserve has indicated that interest rates will remain close to zero for at least the next three years as it aims to hit its new objective of a 2% average inflation target, making any interest rates hikes in response to a rise in inflation unlikely.
Equities may sound more enticing because, in theory, a rise in prices should correspond to a rise in nominal revenues and therefore boost share prices. On the other hand, this may be offset by a contraction in profit margins given an increase in companies’ input costs.
What’s more, the market will often discount those future cash flows at a higher rate when inflation rises to compensate for the fact they are worth less in today’s money.
Where to find shelter from rising inflation
All else being equal, the higher the level of inflation, the greater the discount rate applied to earnings and therefore the lower the price-to-earnings (P/E) ratio investors are prepared to pay (see chart below).
For example, although nothing is certain, if the annual rate of US inflation increased to 4% today, it could result in a P/E ratio of 17x – a fall of 45% from current valuation levels.
Which assets have offered the most consistent inflation protection?
An inflation hedge is an investment that provides protection against price increases. So how often do different asset classes achieve this? And does this vary with the level and direction of inflation?
That’s exactly what we show in the table below: the percentage of rolling 12-month periods since 1973 when investment returns exceeded the US inflation rate by inflation regime. The colours represent how frequently an asset beat inflation from red (poor), through amber (average), to green (good).
Historically, the sweet spot for US equities has been low and rising inflation (where we are today). They outperformed a whopping 90% of the time during such episodes. T-Bills were the worst performer, beating inflation only 36% of the time, while US Treasuries were only marginally better with a 57% success rate.
However, when inflation was high (above 3% on average) and rising, equities and Treasuries underperformed more than half the time. In contrast, commodities and US REITs (real estate investment trusts) came out on top, having outperformed inflation 83% and 67% of the time respectively.
This makes sense. Commodities (e.g. raw materials and energy) are a source of input costs for companies as well as a key component of inflation indices. So by definition, they will perform well when inflation rises.
Similarly, real estate assets offer a partial inflation hedge via the pass-through of price increases in rental contracts and property prices.
US TIPS (Treasury Inflation-Protected Securities) displayed a somewhat disappointing success rate of 63%. This may be because over short holding periods the price impact of movements in real (inflation-adjusted) yields can dominate their inflation-linked income.
For example, a 1% rise in the real yield on 10-year TIPS today would reduce their market value by around 7%, imposing a mark-to-market loss on existing owners.
Meanwhile, although gold is often touted as a hedge against currency debasement fears, its track record isn’t much better. It beat inflation only 64% of the time, less than REITs and commodities.
The price-tag for inflation protection
Incorporating an inflation-hedging asset into a portfolio is no free lunch, as it may increase a portfolio’s risk profile. For example, although REITs and commodities have more desirable inflation-hedging properties, this is likely to come at the expense of more volatile portfolio returns.
TIPS, on the other hand, are historically less volatile. These implicit costs should not be ignored and should be factored into asset allocation decisions.
Investors must decide how much inflation protection they desire and what implicit costs they are willing to tolerate. Regardless, whichever inflation scenario unfolds, traditional equity and bond investors have a lot at stake and cannot afford to be complacent.
DISCLAIMER: This article is for general information and is not intended to address your particular requirements. No individual or company should act upon such information without receiving appropriate professional advice