Is the dog about to bark? How commodities are probably the best bet to protect against inflation

A number of people have asked me what they should invest in if inflation suddenly starts to increase over the next few years. A return to inflation as a major and negative part of economic life would be a generational change. The last time we saw inflation in the double-digits in the developed world wasn’t since since 1990, while most of the past decade has been spent in a desperate effort to raise inflation, not control it. Yet there are emerging signs that inflation could return, perhaps more swiftly than many expect.

To understand how to guard against it, investors first need to be aware of the difference between expected and unexpected inflation. Expected inflation is essentially the market’s consensus view on the future path of inflation. Since financial markets are forward-looking, they presumably incorporate this view into current asset prices. In contrast inflation risk relates to unexpected inflation.

Based on analysis from PIMCO the following assets have performed well during periods of high and unexpected inflation – Treasury Inflation-Protected Securities (TIPS), non-dollar currencies, commodities and gold.

Treasury Inflation-Protected Securities (TIPS) are U.S. Treasury bonds whose value is contractually linked to CPI. As T-bills are frequently considered a “risk-free” asset, inflation expectations are often gauged using T-bill yields. Meanwhile, non-dollar currencies meanwhile may help combat inflation driven by higher prices for imported goods which are brought about by a weaker U.S. dollar.

But by far the most effective assets have been in commodities and gold in particular. Commodities may help hedge against rising food and energy prices and are its most volatile components. Commodity investments can therefore act as a shock absorber for inflation surprises. Gold has characteristics of both a commodity that is easily stored for a long period of time and a currency. It may help provide value in the event of competitive currency devaluations.

Bonds on the other hand, have historically responded negatively to surprises in inflation. Bond prices tend to fall because inflation erodes the value of investments with a fixed income, or yield; it is also associated with rising interest rates.

Equities have traditionally been viewed as an inflation hedge asset class. The theory is simple: a company’s revenues and earnings would also rise with inflation over the course of time. From a long-term perspective, equities may therefore be considered an inflation hedge.

However, the proposition does not always hold over shorter periods of time. Since equities can be thought of as a discounted stream of future cash flows, higher inflation means that the discount rate applied to those cash flows rises, which lowers their current value. Higher interest rates also increase the cost of capital to corporations, and higher inflation means that earnings may be overstated since they depreciate historical cost rather than replacement cost of assets.

For investors looking to increase their exposure to commodities and gold to hedge against an inflation surprise that presents a conundrum. Short of investing in physical gold (the ideal investment if their funds allow) most investors would need to gain exposure to commodities by investing in commodity producers (gold miners and energy companies for example).

Note that the share price of commodity producers are not always correlated with the price of the underlying commodity. Factors such as capital expenditure, government policies, management, balance sheet and accounting practices, unforeseen operational issues (a miners’ strike, for example) and the general appetite among investors can all affect the share price.

Analysing an index of commodity producers (the MSCI All Country World Commodity Producers Index) against an all share index (MSCI All Country) in the 35 years to 2008 showed that producers consistently outperformed the general market when inflation rose above its historical 36 month moving average, but produced mix results when inflation was below this level. However, since the driver for inflation varies over time so the correlation between commodity producers equity values and inflation also varied over time.

In short: To hedge against unexpected inflation risks its probably best to increase your exposure to physical gold and some degree of commodity futures (always being wary of the potential for negative roll yield to erode your returns).

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