Inflation has dominated investment conversations in 2021. Many countries have rebounded strongly from the COVID-19 crisis and are experiencing significantly higher than expected inflation. The annual inflation rate in the United States jumped to 5% in May 2021the highest level since August 2008.
While inflation is a recurring topic for investors, since central banks rolled out their aggressive monetary policies during the global financial crisis, its importance has grown. Although inflation has been on a downward trend since the 1980s, all this money printing has galvanized the inflation hawks. Some have even warned of potential hyperinflation reminiscent of that seen in the Weimar Republic of the 1920s.
2021 Investor Survey: What’s the best way to hedge inflation?
Whether the current higher readings are transitory or structural, how can investors hedge against inflation risk? According to a recent survey of quantitative investors at a JPMorgan conference, 47% of respondents believe commodities are the most effective inflation security, followed by equities (27%), fixed income and Treasury securities protected against inflation (TIPS, 10%). and other instruments (17%).
The case of commodities such as precious metals is clear. For stocks, this is less the case: since active companies can raise their prices at will, according to the theory, they can mitigate the negative effects of high inflation simply by raising their prices at the same time.
Does the data support this argument? Are stocks a hedge against inflation?
Back to US inflation
The average annual inflation rate in the United States was 3.4% between 1947 and 2021. It fell below 0% only about 15% of the time and exceeded 10% only 7% of the time. time. For 57% of the time it was between 0% and 5% and between 5% and 10% about 20% of the time.
For most developed market investors today, their only experience of high inflation is in the history books. Although it is frequently discussed, few traders have direct experience of the havoc it can wreak on economies and financial markets.
Annual inflation in the United States
Stock returns under different inflation regimes
We created four inflation regimes for the period 1947 to 2021 using inflation data from the St. Louis Federal Reserve and stock market data from the French data library Kenneth R..
Average monthly equity returns were comparable across these different environments. The weakest returns have occurred during periods of deflation, which generally coincide with economic recessions. However, inflation above 10% does not seem to have had a negative impact on stock market returns.
Monthly U.S. stock returns by inflation regime, 1947 to 2021
Real vs nominal returns
Of course, analyzing returns without adjusting for inflation is a simple but common mistake. A savings account with an interest rate of 2% is quite attractive when inflation is 0%, but less so when it is 3% and implies a negative real interest rate.
Comparing nominal and real monthly equity returns under the four inflation regimes yields a very different perspective. In real terms, inflation above 5% detracted sharply from returns, while inflation above 10% essentially made equities unattractive.
Perhaps the real return is still positive and so stocks have hedged against inflation. Nonetheless, equities are volatile instruments and the average return masks the dramatic declines that have occurred over the 70 years in question.
Real monthly returns of U.S. stocks by inflation regime, 1947 to 2021
So which sectors suffered the most during higher inflation regimes? Our analysis of the 30 sectors covered by the Kenneth R. French Data Library revealed that when inflation exceeded 10%, the sectors most affected were those that dealt directly with consumers – consumer goods, automobiles, retail, etc. . Despite their ability to adjust their prices at will, these businesses seem to have trouble passing on the increases to their customers.
The European financial services industry is a current manifestation of this. Banks have been reluctant to impose negative interest rates on their retail savings accounts, but have nonetheless imposed negative rates on deposits from asset managers and other institutional clients.
Real Monthly U.S. Stock Returns: The 10 Worst Sectors During Times of High Inflation, 1947 to 2021
The same sectors did not uniformly underperform when inflation hovered between 5% and 10%. Some even generated positive returns. In contrast, the sectors that benefited the most from high inflation were nearly identical during the two higher inflation regimes: specifically, energy and materials, which investors often rely on to position their investment portfolios. actions for higher inflation.
Real Monthly U.S. Equity Returns: 10 Best Sectors in Times of High Inflation, 1947 to 2021
While this confirms the inflation hedging properties of the usual suspects, there are caveats. Both high inflation regimes occurred primarily during the 1970s, when inflation in the United States reached 23.6%. Inflation was influenced by a spike in oil prices due to an OPEC embargo. The price of WTI crude rose from $4 a barrel in 1973 to over $10 in 1974 and then to $40 in 1980.
Oil price volatility is expected to remain here amid the geopolitical turmoil and, theoretically, prices could reach new highs. But the world is reducing its reliance on fossil fuels, and America’s fracking industry has helped boost supply. So, although the energy sector has always been a good bet against inflation, this trend may not persist in the future.
So what if we remove the boom and bust cycle from oil prices and exclude the period from 1973 to 1986 from our analysis? The same 10 sectors still do well in high inflation regimes not driven by oil prices.
Real Monthly US Stock Returns: 10 Best Non-Oil Crisis Sectors from 1973 to 1986
Although some equity sectors have exhibited inflation hedging characteristics, this data is of little practical value. To be useful, it would require skills in market-timing. Additionally, these stocks are commodity proxies, so even if investors could predict inflation, they would likely be better served by holding direct exposure to commodities.
And the arguments in favor of holding raw materials are tenuous. The Goldman Sachs Commodity Index (GSCI) is trading today roughly where it was in 1990. Such a position would be unbearable for most investors. A bet on commodities is a bet against human progress: it’s probably a losing proposition in the long run.
A more attractive inflation hedge might be to invest in trend-following commodity-focused funds or commodity trading advisors (CTAs). If oil or gold prices rise due to higher inflation, these funds will jump on the trend sooner or later. If prices fall in an environment of falling inflation, investors may short these asset classes. Naturally, this strategy won’t work perfectly all the time – the last 10 years are a stark reminder of that – but it can be a more elegant way to hedge against both inflation and deflation.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
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