Which asset is the best hedge against inflation?

In an interview with Bloomberg TV, the Finnish governor of the European Central Bank, Olli Rehn said that the Eurozone’s inflation outlook is “too low for my taste, and more importantly, too low for our aim”. Rehn goes on to argue that the ECB’s inflation goal should be changed to a clear 2%, rather than the current position which is just under 2% over the medium term. How to meet the 2% goal? “I would not enter into a speculation on one or another instrument in our monetary toolbox”, Rehn responds, “I would just say we are indeed ready to use and adjust all our instruments as appropriate,”

According to the quantity theory of money, an increase in the money supply can cause inflation unless it is matched by output growth or offset by a slowing of the velocity of money. The past year has seen a sharp increase in money supply, but this has been tempered by a reduction in the velocity (circulation) of money. Being ready to “use and adjust all our instruments as appropriate” implies measures that ensures greater money supply translates into more circulation, more economic activity and potentially then higher inflation.

Rising shipping rates, lengthening delivery times and production bottlenecks have also served to reignite the inflation risk. For while latest official reports of consumer price inflation are anemic that could be set to change in twelve months time as manufacturers pass on higher input costs onto the end consumer. As the global economy adjusts to the pandemic and the changing political landscape bottlenecks in the real economy are unlikely to be smoothed out soon. If the ECB and other central banks underestimate this then there is a risk that inflation becomes much more entrenched than we’ve become accustomed to.

Given that potential macroeconomic backdrop what should investors do to bet on higher inflation? For any strategy to be successful an investor must believe that the market has underestimated the inflationary risk, and act before resurgent inflationary expectations are reflected in the price.

Any assessment of the performance of assets under particular inflationary regimes suffer from very poor sampling methods. First, it is often difficult to disentangle the impact of price performance from other economic data, i.e. manufacturing activity, energy consumption etc. Second, there is really only one period of very high inflation since fiat money became the standard since 1973; other periods of high inflation occurred under different monetary regimes.

Analysis by JP Morgan looks at the relative performance of different asset classes since 1988, under low or high inflation periods (so clearly missing out the very high inflation of the 70’s) and whether the inflation rate was rising or falling. Under ‘low and rising inflation’ periods (similar to where we are now), emerging market equities and gold have tended to be the strongest performing assets. Whenever high inflation has taken hold however emerging market equity outperforms everything else by a wide margin. The usual suspects – commodities and gold specifically – tend not to perform as strongly as you might expect.

The results make sense given the time period. Emerging economy equities have tended to be a leveraged bet on commodity prices and so would have outperformed during the commodity super-cycle upswing from the late 1990’s. Early signs of a weak dollar and rising commodity prices tend to be beneficial to emerging economies, particularly commodity producers. In these cycles, emerging market currencies appreciate and their domestic economies benefit from the expansion in liquidity and credit with stock returns potentially significantly higher in US dollar terms.

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The previous charts show the inflation performance of aggregate indices. However, individual sectors of the equity market are more sensitive to inflation than others. The chart on the left below shows sectors of the US equity market since 1995. The stand-out sectors are energy, tech, energy-related utilities, industrial’s (especially capital goods), communications and materials (especially metals and mining). Analysis of European equity sectors’ sensitivities to eurozone inflation gives similar results.

Meanwhile, the chart on the right shows the sensitivity of individual commodities to inflation. Perhaps surprisingly, base metals such as copper perform better under inflation than either energy or precious metals. Unlike the equity market – where a focus on commodity related stocks can act as a hedge – a basket of commodities tends to perform better than it’s individual parts. This might be because the diversified commodity basket has reduced the impact of other macroeconomic factors (for example, a slowdown in manufacturing pulling down base metal prices) and so enabling a better proxy for overall inflation.

Remember though that just because a particular asset has been a suitable hedge against inflation in the past does not mean it will perform as well in the future. In an interview with Jack Schwager in the 1989 book Market Wizards, veteran commodity investor Jim Rogers outlines his concerns about gold as an inflation hedge:

“Generals always fight the last war. Portfolio managers always invest in the last bull market. The idea that gold has always been the great store of value is absurd. There have been many times in history when gold has lost purchasing power—sometimes for decades.”

Emerging market equities, commodities and commodity related equities have performed strongly over the past year (a period of low inflation but rising inflationary expectation). That appears to be consistent with the pattern of the past 30 years. However, that doesn’t mean they will continue to perform should inflation rise further. Each inflationary period is unique, each with its own set of reasons and that may mean that different combinations of assets perform better.

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