This is a guest post by Ben Funnell, Portfolio Manager at Man Group, and Campbell R. Harvey, Professor at Duke University and Investment Strategy Advisor at Man Group. It is based on their recent research, “The best strategies for inflationary times“, Which was written jointly with Teun Draaisma, Henry Neville and Otto Van Hemert of the Man Group.
Do you remember the last time US inflation exceeded 5 percent? The answer, remarkably, is 1990 – long before most of today’s investors even came into the picture. But with the CPI hitting 4.2 percent in April and most large wealthy owners currently longing stocks and bonds – asset classes that have suffered from inflation in the past – it is a good time to start evaluating alternative inflation hedging strategies.
In a newly published research paper on SSRN, the authors attempt to provide some insight into the best strategies.
It should be emphasized that our research does not aim to predict the level of inflation, but rather falls back on 34 inflation episodes in the US, UK and Japan (using nearly a century of data) to understand the impact of inflation on asset prices.
To understand the risks, the article also analyzes eight U.S. price hikes over the past 95 years, with inflation starting from a moderate level and soaring above 5 percent – a situation that we think could easily occur in the quarters ahead. We then focus on the effects of inflation on various passive and active strategies that reduce risk and potentially contribute to more pain.
A key finding is that it pays to act sooner rather than later. Traditional 60-40 equity bond portfolios with no inflation protection are likely to suffer if history repeats itself. Past experience shows that the S&P stock market index is likely to be hit during spurts of inflation and will lose an average of 7 percent in real annualized terms (after adjusting for inflation). But even fixed-income securities offer no breathing space, because rising interest rates have led to falling bond prices in the past. An unprotected 60-40 portfolio is therefore a risk exus.
So what was it really like to invest in previous periods of unexpectedly high inflation? As a guide, we looked at Warren Buffett’s acclaimed letters to shareholders from the late 1970s and early 1980s, a time when inflation peaked at nearly 15 percent and mortgage rates topped 20 percent. Buffett does not strike, as this passage shows in a letter from 1980:
Inflation rates not far removed from those seen in recent years can turn the positive returns generated by a majority of businesses into negative returns for all owners. At current inflation rates, we believe that individual owners should not expect real long-term returns from the average American company.
In a 1977 article for Fortune Magazine, Buffett put his thoughts even more bluntly:
The inflation tax has a fantastic ability to simply deplete capital. . . If you feel like you are dancing in and out of securities with no inflation tax, I want to be your broker – but not your partner.
But let’s apply that logic to today. The US had a deficit of 15 percent of GDP in 2020. The Congressional Budget Office also expects a deficit of several trillion dollars in 2021. This would be the first double-digit year of deficit in a row since World War II. Quantitative easing fueled by Covid has also resulted in the Federal Reserve’s balance sheet nearly doubling. And this time around, the money supply is growing – the US M2 has grown at an annualized rate of 26 percent since February last year, when the policy response began in earnest. Even for the prudent, all of this screams danger.
So if stocks and bonds fail the inflation test, where should investors go? As clichéd as it sounds, our research shows that commodities have proven to be a solid historical hedge because of the primary role that commodity prices play in driving inflation. During episodes of inflation, the energy complex averaged 41 percent, while industrial raw materials averaged 19 percent – both on a real basis. Gold and silver have also offered low double-digit returns.
Inflation Protected Treasury Securities (TIPS) are also being developed to hedge against inflation risks. However, this type of protection comes at a cost. The current rate of the hedge is high given negative initial returns: In inflation-free times, unlike some other assets, investors would have to bear negative real returns.
Active strategies are another option. For example, time series momentum, a strategy aimed at capitalizing on sustained downward or upward markets, has delivered an annualized real return of 25 percent over the past eight inflationary episodes.
But there is a problem. Commodities, trend-following strategies and TIPS have impressive inflation balances, but offer only limited opportunities for participation. Therefore, high capacity active equity strategies must also be considered.
In this context, the two best-performing stock sectors (not surprisingly) are those linked to the energy complex, which have tended to have delivered a 1 percent real return. The health sector is the second best performer with -1 percent. Durable goods, however, tended to be taken by surprise with a real return of -15 percent.
More generally speaking, active strategies that focus on “quality” provide a return of 3 percent, while “value” yields -1 percent (after transaction costs). And while this may seem modest, those returns are well above the -7 percent for stocks in general. In addition, these strategies are highly scalable, an important consideration for many of the big players in the market.
Collect and get an alternative
However, our research went beyond traditional financial assets. It noted that alternatives such as real estate, as well as three collectibles (especially art, stamps, and wine) should also be considered in inflation-resistant strategies. Collectibles, while much more difficult to access for the average retail and institutional investor, delivered impressive returns during inflation, with wine rising as much as 7 percent as inflation spiked.
The following graph shows the average real annualized total return of the asset classes during the eight US inflation episodes examined *:
But what about new asset classes like cryptocurrencies? Theoretically, cryptocurrencies have no direct relation to the monetary policy of a central bank. For example, Bitcoin’s money supply is algorithmically based and the last fraction of a Bitcoin is produced in 2140.
So will cryptocurrencies offer protection? We obviously have no empirical data. Cryptocurrencies have yet to experience a surge in inflation against which they need to be tested. Quality data will only be available from 2013 – well after the last surge in inflation that hit western markets. Second, many cryptocurrencies seem to behave like risk assets. In the first quarter of 2020, for example, the stock markets lost 34 percent and Bitcoin by an even more 51 percent. As investors began to return to risky assets, the stock market soared, as did bitcoin.
This analysis suggests that cryptocurrencies like Bitcoin do not necessarily behave independently of the stock market. Hence, the limited history suggests that the volatile cryptos will be an unreliable inflation hedge at best.
Overall, however, the investigation is reassuring. We find that a rebound in inflation doesn’t have to be catastrophic for a properly positioned portfolio. Of course, a likely rotation in defensive strategies could be effective in and of itself. As of now, the world’s 20 largest wealthy owners, with assets of around $ 11 trillion, have an overall allocation of 49 percent in stocks and 34 percent in bonds. Their combined raw material weight is less than 1 percent.
That said, if you’re a 60-40 investor with no inflation protection, you could potentially get caught if you don’t act fast enough.
* Commodity price action is derived from front-end futures contracts from the Man AHL database, while trend-following performance is generated from an internal time-series momentum strategy based on liquid futures and forwards (or proxies) across all assets is applied. For wine we use the index created in Dimson, Rousseau and Spaenjers 2013. For TIPS we use a backcast designed by Goldman Sachs. The equity comes from Standard and Poor’s, while the government bonds come from the global financial database. All sector and style portfolios are from the Kenneth R. French database. All data are from 1926 to the present day. The US residential real estate data comes from Case-Shiller’s US house price index.