While we are decidedly in the camp that believes inflation is transitory, hedging a portfolio against inflation has been a key focus.
Inflation has been the hot topic in markets lately, and for good reason. Getting the inflation question right is perhaps the most important decision that will affect long-term returns. While we are decidedly in the camp that believes inflation is transitory, the current burst of demand coupled with a lack of supply in specific segments of the economy is pushing up prices in the near term, and raising questions about whether we are facing a new inflationary regime.
Our outlook calls for “reflation” – aka inflation trending higher from a low base, but unlikely to sustainably overshoot the Fed’s 2% objective for several years. We think that once the supply/demand mismatches subside, inflation will fall back to the Fed’s target range. That said, many clients disagree – thinking inflation will come well in excess of the Fed’s 2% mandate – or that inflation will come without a corresponding pick-up in growth. For those that disagree, hedging a portfolio against inflation has been a key focus of late.
So what are the best hedges? Which asset classes perform best when inflation persistently accelerates?
To get a sense of which assets outperform when inflation rises, we looked at past performance in different inflationary regimes, making a distinction between the periods pre- and post-hyperglobalization.
As we pointed out in a previous report, structural inflation declined substantially in the late 1990s due to globalization, technology, and demographics. While these forces are shifting at the margins, we don’t think this backdrop will change anytime soon. Therefore we have to consider a rise in inflation relative to the trend in each regime, as opposed to from an absolute level.
Since the world today looks very different from the world of the 1970s, it makes an inflation comparison less relevant. For example, from 1965-1998, core inflation in the U.S. averaged 4.6% y/y and with such wide dispersion that a rise above 6% was still within one standard deviation from the average. However, in the period post-1998, inflation averaged 1.67% and inflation above 2.4% would have sat comfortably above two standard deviations!
In other words, core inflation in the globalization era (post-1990s) has been remarkably low and consistent. Therefore, while it can be useful to look at how assets performed in different absolute levels of inflation, such as the work done by our investment bank, in many cases it can be an apples-to-oranges comparison.
For example, looking at asset performance during periods of inflation in the range of 3-6%, pre-1990s this would have been average inflation, however in the current era that would likely be considered an alarming rate of inflation. Instead, we looked at how assets performed when inflation deviates from the mean so as to make a more equitable comparison over periods with very different structural forces.
We look simply at two scenarios: inflation rising slightly above the average (we define average as one standard deviation above the mean) and inflation rising substantially above the average (rising to two standard deviations from the mean). We divided the time periods into pre- and post-globalization and then compared results across time frames based on the average inflation rate in each inflation regime. The results are intuitive but still instructive for portfolio allocation.
How should investors position for a moderate inflation overshoot? When inflation rises from the average (as in a reflationary environment like we’re expecting) risk assets perform well, with U.S. equities, oil, energy stocks, and real estate outperforming.
Broadly, portfolios should reallocate from bonds to equities and commodities. Within equities, energy outperformed, and within commodities, energy outperformed agriculture or materials.
However, inflation is a process rather than an event. When inflation moves from a benign reflationary environment to one where it begins to rise substantially, whether due to supply shocks (labor or commodities) or substantial stimulus-driven demand, real assets (such as real estate, commodities, energy equities) significantly outperform financial assets (bonds, credit, equities).
Within equities, energy companies also stand out for their outperformance. This is because the forces that generate high levels of inflation often begin with stress in supply-constrained markets like commodities, with high pass-through to producer stocks in Energy.
Underperformers are commodity currencies, credit relative to bonds, the USD, and overall US equities, which in periods of high inflation often fail to provide positive real returns.
Lastly, in both scenarios gold tends to do well. It’s often because rising inflation produces deeply negative real rates, which boosts gold. However, in this environment we are already looking at deeply negative real interest rates and going forward we expect real rates to rise and nominal yields to pick up. Nonetheless, as a hedge against higher inflation, gold also makes sense.
All market and economic data as of May 31, 2021 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.
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