This is a guest article 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 inflation timesWhich was co-written with Teun Draaisma of Man Group, Henry Neville and Otto Van Hemert.
Do you remember the last time the inflation rate in the United States exceeded 5%? The answer, incredibly, is 1990 – long before most investors operating today got into the game. But with the April CPI hitting 4.2% and most of the major long-asset owners are equities. and bonds – asset classes that have historically suffered from inflation – now is a good time to start evaluating alternative inflation hedging strategies.
In a recently published research article in SSRN, the authors attempt to provide insight into the best strategies.
Our research, it should be emphasized, is not designed to forecast the level of inflation but rather relies on 34 inflation episodes in the United States, United Kingdom and Japan (using almost a century of data) to understand the impact of inflation on asset prices.
To understand the risks, the article also analyzes eight price spikes in the United States over the past 95 years, where inflation started from a moderate level and exceeded 5% – a situation which, according to authors, could easily be played out in the quarters to come. We then focus on the impact of inflation on various passive and active strategies, which mitigate risk and potentially contribute to more pain.
One of the main findings is that it pays to act as early as possible. Traditional 60-40 equity-bond portfolios without inflation hedging may suffer if history repeats itself. Past experience, taken from U.S. equity returns from Professor Shiller’s CAPE 1926-2020 database, also indicates that stocks risk being hammered during inflation spurts, losing an average of 7% in annualized real terms. (after adjustment for inflation). But fixed-income securities don’t offer a break either, as rising rates have always pushed bond prices down. An unprotected 60-40 portfolio is therefore a risk link.
So what was it really like to invest in previous periods of high inflation? For a clue, we looked at Warren Buffett’s famous Letters to Shareholders from the late 1970s and early 1980s, a time when inflation in the United States peaked at nearly 15% and mortgage rates exceeded 20%. Buffett does not fire any punches as can be seen from this passage in a 1980 letter:
Inflation rates close to those recently recorded can transform the level of positive returns obtained by a majority of companies into negative returns for all owners. At current inflation rates, we believe that individual owners should not expect any real long-term return from the average US corporation.
In a 1977 article for Fortune Magazine, Buffett laid out his thoughts in even clearer terms:
The inflation tax has a fantastic ability to simply consume capital. . . If you feel like you can dance in and out of headlines in a way that defeats the inflationary tax, I would love to be your broker – but not your partner.
But let’s apply that logic to today. The United States recorded a deficit of 15% of GDP in 2020. The Congressional Budget Office also expects a deficit of several trillions of dollars in 2021. It would be the first consecutive year of double-digit deficit since World War II global. Covid-fueled quantitative easing also led the Federal Reserve’s balance sheet to nearly double in size. And this time around, the money supply is growing – US M2 has grown at an annualized rate of 26 percent since February of last year, when the policy response in earnest began. Even with cold heads, it all screams risk.
So if stocks and bonds fail the inflation test, where should investors flee? As cliché as it sounds, our research shows that commodities have proven to be a strong historical hedge due to the role commodity prices play in the inflation spurt in the first place. During episodes of inflation, the energy complex returned an average of 41 percent while industrial commodities returned 19 percent – both on an actual basis. Gold and silver also offered low double-digit returns.
Inflation-Protected Treasury Securities (TIPs) are also designed to hedge against inflation risk. However, there is a cost for this type of coverage. The current price of the hedge is high given the negative starting yields: Investors would have to put up with negative real yields during non-inflationary times, unlike some other assets.
Another option is active strategies. For example, Time Series Momentum, a strategy designed to profit from sustained bear or bull markets, has produced an annualized real return of 25% over the last eight episodes of inflation.
But there is a problem. While commodities trending strategies and TIPs have offered an impressive history of inflation, they offer limited ability to participate. Therefore, high capacity active action strategies should also be considered.
In this context, the two best performing actions (unsurprisingly) are those related to the energy complex, which have tended to yield 1% in real terms. The health sector is the second best performer with -1 percent. Durable consumer goods, however, tended to be caught off guard with a -15 percent return.
More generally, active strategies focused on “quality” offer a return of 3% while “value” produces -1% (after transaction costs). And while it may sound modest, these returns are well above the -7 percent of equity in general. Additionally, these strategies are highly scalable, an important consideration for many large market players.
Obtaining collection and alternative
Our research, however, has gone beyond traditional financial assets. He discovered that alternatives such as real estate as well as three collectibles (especially art, stamps and wine) should also be factored into strategies relating to inflation regimes. Collectibles, while much more difficult to access for average retail and institutional investors, have provided impressive returns during inflation, with wine rising as much as 7% during inflation surges.
The chart below shows the average real annualized total return of asset classes over the eight US inflationary episodes studied *:
But what about new asset classes like cryptocurrencies? Theoretically, cryptocurrencies have no direct connection with the monetary policy of a central bank. For example, bitcoin’s money supply is algorithm-based and the last fraction of a bitcoin will be produced in 2140.
So, will cryptocurrencies provide cover? Empirically, we obviously have no data. Cryptocurrencies have yet to experience a period of massive inflation to be tested. Good data only exists as of 2013 – well after the last surge in inflation to hit Western markets. Second, many cryptocurrencies seem to behave like risky assets. For example, in the first quarter of 2020, the stock markets lost 34% and bitcoin fell even more than 51%. As investors began to revert to risky assets, the stock market rose sharply, as did bitcoin.
This analysis suggests that cryptocurrencies like bitcoin do not necessarily behave independently of the stock market. As such, the limited history suggests that cryptos will be an unreliable inflation hedge at best.
Overall, however, the research is reassuring. He notes that a rise in inflation is not necessarily catastrophic for his portfolio if one is correctly positioned. Of course, a likely rotation to defensive strategies could have an impact in itself. Currently, the world’s 20 largest asset owners, representing some $ 11 billion in assets, currently have an aggregate allocation of 49% in stocks and 34% in bonds. Their combined product weight is less than 1 percent.
This means that if you are a 60-40 investor helpless against inflation, you could be caught off guard if you don’t act fast enough.
* Commodity price performance is derived from forward futures contracts taken from the Man AHL database, while trend following performance is constructed from an internal time series momentum strategy applied to forward contracts. liquid term and term (or proxy) on the assets. For wine, we use the index built in the article by Domson, Rousseau and Spaeniers 2013. For TIPs, we use a back-cast built by Goldman Sachs. Equity comes from Professor Shiller, while Treasuries come from a global financial database. All sector and style portfolios are taken from the Kenneth R. French database. All data is from 1926 to the present day. US residential real estate data is taken from the Case-Shiller US Housing Price Index.