Since our last post on inflation, the rise in prices has only accelerated. Headline inflation over the last 12 months exceeded 7% in December 2021. What can we do as investors to try to protect against the very real possibility that high inflation sustains or gets further out of hand? Let’s discuss what the historical evidence says about effective inflation hedges. Additionally, we’ll address the unique considerations for impact investors. We’ll give you our take on seeking inflation protection while still staying true to your values or investing sustainably.
The Myths vs. the Promising Hedges
We first need to discriminate between the myths and the truly promising inflation hedges based on a thorough look at history. To do so, we’ll refer to a study published last year called “The Best Strategies for Inflationary Times” (the Man Group study). It examined the hard data on which investments performed well in past periods of high inflation. The authors were able to extend the analysis back before World War II and include a wide selection of investments. This table summarizes their findings:
Our takeaways are
- several investments frequently thrown out as potential inflation hedges haven’t performed well at all and
- investments that do have a great track record of performing well during inflationary times, strangely, are not widely held by investors and advisors rarely recommend them.
Let’s tackle the myths first:
The Myths
Stocks: Many advisors and portfolio managers repeat the idea that stocks are an inflation hedge. Ditto for stocks’ less-risky but highly correlated cousins: corporate bonds (whether investment-grade or below-investment-grade). According to the Man Group study, though, stocks have lost 7% annually after inflation during inflationary periods in the US. Corporate bonds, surprisingly, did just as bad. The doesn’t seem like businesses have been successful historically at passing off rising input costs onto their customers.
Residential Real Estate: We also see it repeated that real estate is one of the effective inflation hedges. Not in the heat of an inflationary period, though. According to the Man Group study, house prices fell by 2% annually, adjusted for inflation, during inflationary periods. Now, this excludes any rental income that may be earned and doesn’t consider the many other real estate sectors. So this could understate the actual return an investor could have earned in our opinion. And to be clear, we’re not saying it’s a bad idea to buy a home if it’s your personal residence. But as an investment (a rental property, for instance), residential real estate doesn’t look like a great investment specifically to hedge inflation.
Short-Term Bonds: A commonly employed defensive option is to shorten your bonds’ maturity dates (the date when a bond’s principal amount is scheduled to be paid back). This should defend against a common side effect of inflation—rising interest rates—but not necessarily inflation itself. The Man Group study shows shorter-term bonds still lost value after inflation during inflationary episodes (-3% annualized). But they did much better than longer-term bonds. This is because if interest rates are rising due to inflation, the proceeds of bonds that mature quicker can be reinvested into higher-yielding securities sooner. For lower-risk portfolios, short-term bonds may be the best thing an investor can do since more historically reliable inflation hedges come with higher volatility.
The Promising Inflation Hedges
Trend-Following Strategies: By far, the best-performing strategy in inflationary times was trend-following strategies, beating out even pure commodities. Trend-following fund managers seek to profit from the momentum effect—the observation that markets often move in tradable trends over time. Trend-following has a long and well-documented track record of profitability across asset classes from stocks and interest rates to currencies and commodities.2 Importantly, that track record has been consistent across multiple inflationary episodes. And unlike commodities-only investing, trend following tends to perform similarly outside of inflationary periods too. So if you’re wrong about inflation, we think there is less downside. The strategy lends itself to a set-it-and-just-rebalance-it type of position an investor can hold over time.
Commodities: The next-best inflationary asset has been commodities. This makes intuitive sense: Commodities represent the cost inputs for many businesses, and inflation means rising costs. Commodity investing presents some concerns, though. First, they can be very volatile—as volatile as stocks or higher. Second, they have been correlated to the stock market, at least recently. And third, while they are among the best performers during inflationary times, they typically perform poorly in all other times.
In Hesperian portfolios, we address these issues in a few ways: We may limit commodity exposure for more conservative investors. We may delegate some of the exposure to sophisticated trend-following fund managers who have the flexibility and capabilities to bet on or even against various commodities as part of a diversified active strategy. We incorporate economic cycle and momentum/trend analyses into our own investment process to determine whether an additional tactical allocation to commodities makes sense to us. Furthermore, as humble investors, we look for commodities funds we think can deliver the bulk of commodities’ upside if we’re right about our tactical decision while still offering less downside or volatility if we’re wrong.
Commodity Stocks: One qualification to the finding that stocks perform poorly during inflationary times is that energy stocks have historically produced at least a positive inflation-adjusted return. But compared to the strength and consistency of trend-following and commodity strategies’ performance during inflationary periods, commodity stocks appear to be a much more inferior option.
The Impact Considerations
Impact investors may be concerned that investing in trend-following strategies (which can invest in commodities) or directly in commodities may not be consistent with their values or sustainability objectives. If you’re impact-minded, let us ease your concerns. Despite the word “commodities”, neither of these strategies invest directly in extractive, polluting activities. Rather, they invest in futures contracts, which in our view, are akin to private bets on prices between two individuals, with limited impact on the real economy. We don’t believe investing in commodity futures hurts the environment. Commodity prices reflect climate risk, they don’t cause it. So we think impact investors should feel no qualms about availing themselves of these types of strategies if they want to add inflation protection to their portfolios.
The same cannot be said about investing in commodity stocks. There we do think it’s reasonable to feel responsible for those companies’ negative externalities as a stockholder—you are literally an owner of the business. Fortunately, it appears trend-following and commodity strategies have been the far better inflation hedges.
We’d argue commodities investing is a natural tool for the sustainable investor. Commodities can play a central role in making all our nest eggs of savings more resilient in the face of climate risk. In their recent market outlook, Bridgewater Associates outlined four different ways climate change could feed into inflation (or has already).3 Hopefully, if commodity prices continue to rise in response, they’ll provide a greater incentive for entrepreneurs, inventors, and researchers to bet on and develop newer, cleaner, and eventually cheaper technologies and energy sources, which will be essential to getting us out of this mess.
The Maybes
Gold: Gold seems to have a strong association with inflation, but in reality, the relationship is more complicated. We include gold in our arsenal as portfolio managers but separate it from inflation and other commodities given its unique characteristics.4
Collectibles: This area is interesting and underallocated to. We are currently researching fine art and wine, in particular. But we need to gain a deeper understanding of these areas, complete due diligence on the new platforms that have emerged to offer all investors access, and conduct a deeper analysis on the various historical data sets out there so we know whether they belong in a portfolio and at what position size.
TIPS: On the bond side, one possible way to protect against inflation is to invest in inflation-protected Treasury securities, or TIPS. These bonds’ principal and coupon payments are indexed to inflation. In the Man Group study, TIPS was the only bond category studied that generated a positive inflation-adjusted return. However, TIPS come with caveats.5
Crypto: The Man Group study dismisses bitcoin without deep analysis. We remain open-minded, but we have not seen data yet that shows cryptocurrencies exhibit a positive relationship with inflation. They appear to behave like very, very, very, very, very volatile stocks. Plus, they lack a long historical track record to study, and some may come with serious impact concerns.
Do You Need Inflation Hedges in Your Portfolio?
Much of the commentary we read seems to define an inflation hedge as anything that goes up over the long term. By that definition, which is so broad as to be meaningless, just stick with traditional stocks and bonds and check back in on your portfolio in 20 years. But you may have near-term or intermediate-term financial goals in addition to long-term goals and so don’t have that luxury. Your investment return (especially on an after-inflation basis) and the volatility of your return path can matter quite a deal. They can materially impact your probability of achieving your financial objectives and when exactly you’re able to accomplish them. We think a sound financial plan and a professionally managed tactical investment strategy go hand in hand and feed into each other. Both are important.
It’s impossible to say whether any of the investments we discussed above are appropriate for you without knowing your complete financial picture. But nothing has changed our view that inflation risk is high today. Still, any consideration of inflation hedges should be done through the lens of history and involve a close review of hard data. If you have concerns about inflation or your portfolio, reach out to us here to learn how as your personal wealth manager we can help.
Eric R. Figueroa, CFP®
I am a Folsom, CA, fee-only wealth manager serving the Greater Sacramento area, California Gold Country, and the nation virtually. I offer financial planning and investment management, specializing in impact investing and personalized values-based investing.
All content presented in this article is for informational purposes only. Materials presented should not be interpreted as a solicitation or offer to buy or sell a security or the rendering of personalized investment advice, which can only be provided through one-on-one communication with a financial advisor. The content reflects the opinions of Hesperian Wealth LLC (HW), except where cited, which are subject to change at any time without notice. The information contained herein has been obtained from sources believed to be reliable, but the accuracy of the information cannot be guaranteed. All information or ideas provided should be discussed in detail with a financial, tax, or legal advisor prior to implementation.
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1 Selected data points from the study. Annualized Inflation-Adjusted Return calculated during the last eight US inflationary periods, as defined by the authors, back to 1941. Hit Rate is calculated as the number of inflationary periods when the investment’s inflation-adjusted return was positive divided by the number of possible periods. Myth or Promising Hedge? and Impact Concerns are based Hesperian opinion and commentary.
Note, the authors did not have commodity returns for the 1941 inflationary episode, the authors only include returns for gold for the last three inflationary periods, and the return for TIPS comes partially from a simulated record and only extends back five inflationary periods. Thus, these three are not exactly comparable to the other investments analyzed, though commodity futures has roughly the same history as the others.
2 AQR’s “A Century of Evidence on Trend-Following Investing”; Trend Following with Managed Futures: The Search for Crisis Alpha by Alex Greyserman and Kathryn Kaminski
3 Bridgewater Associates’ “Looking Ahead to 2022, with a Focus on Social and Environmental Drivers of Markets”
4 The reason we place gold in the “Maybes” despite the strong historical return and high hit rate is that prior to 1972, the price of gold was fixed in dollar terms so there’s no US dollar–denominated performance before then to analyze. The period between 1972 and today seems like a long time, but in the context of human history, it’s not much. On one hand, the Man Group study doesn’t include gold’s strong performance during the late 1960s. This would have boosted gold’s performance and hit rate higher. On the other hand, one of gold’s biggest bull markets, in the aftermath of the 2008 financial crisis, came at a time when we were struggling with deflationary forces.
Clearly, there is some complex nonlinear relationship between gold and inflation or else there are multiple fluctuating drivers of gold’s performance that can’t be easily sussed out. We think gold shouldn’t be viewed as an inflation hedge, but as a unique alternative investment whose consistently low correlation to bonds and stocks may make it an interesting diversifier when its price is trending upward. From the point of view of a trend follower, it doesn’t matter why some investors find gold attractive or why it’s performing this way or that way. It’s just another security that exhibits tradable price trends over time.
As for impact concerns, while the gold mining process can be a dirty one (and rules out investments in gold mining companies), the gold bullion you invest in when you buy a gold fund has already been mined. The damage has been done by others and the climate impact of keeping gold bars in a vault is low. You can also invest in gold futures rather than gold directly, which is another step removed from any environmental impact.
5 TIPS’ consistency (called “Hit Rate” in the Man Group study) is lower than the other promising inflation hedges identified. TIPS only kept up with inflation in three of the last five inflationary episodes. This is probably because (1) TIPS are still susceptible to rising interest rates. If interest rates rise because of inflation, TIPS prices can fall at the same time inflation rises, offsetting a portion or all of the inflation-compensation component. And (2) the market’s current inflation expectations for the future are embedded in TIPS prices. So any investor in TIPS only benefits if inflation surprises higher than that. Whenever Hesperian is considering TIPS, we assess not whether inflation will increase, but whether inflation will exceed the consensus opinion. It’s completely possible to invest in TIPS, have higher inflation come to pass as you predicted, and not benefit from it because the price you paid for TIPS already factored in that higher inflation.