Inflation hedges are increasingly difficult to find for individual investors
The search for safe havens after the worst inflation in four decades seems about to become much more real. The bad news is that the task does not seem at all easy or simple, at least for individual investors whose choices are limited to standard asset classes and who rely on a traditional 60-40 portfolio of stocks and shares. bonds to weather the rises. and downturns in market cycles. If U.S. policymakers follow through on their aggressive tightening rhetoric, we could be in for some tough times. The surge in US consumer prices has long passed the point where it could be considered temporary, but the stock market has remained remarkably resilient. The benchmark S&P 500 index was within 6% of January’s record high at Friday’s close. The problem for investors who are betting that the markets will overcome this surge in inflation without serious damage is that their confidence is part of the problem. Monetary policy works through financial conditions, and falling stock and bond prices tighten them, as Bill Dudley, former president of the Federal Reserve Bank of New York, wrote for Bloomberg Opinion last week. The longer the markets remain buoyant, the more the Fed may need to raise interest rates to achieve the desired outcome. How should investors react then? One of the most downloaded articles in the past 12 months on the SSRN academic research site is titled “The Best Strategies in Times of Inflation.” The study, by researchers at hedge fund firm Man Group Plc and Duke University, makes for uncomfortable reading. Drawing on nearly a century of data for the US, UK and Japan, he concludes that stocks and bonds perform poorly in times of inflation. The annualized real return for US equities has averaged -7% in eight such periods since World War II. Real estate does not offer much refuge: it also provides negative real returns, but not of a significant magnitude. The only major asset class that reliably outperforms when inflation is high and rising is commodities, with an average real return of 14%. It was an auspicious and very useful observation – in March 2021, when the article was first published. The problem is that commodities have been wreaking havoc for months, so those who have only just become aware of the harshness of the Fed’s language last week may have already missed the mark. The Bloomberg Commodity Index is up 48% in the past year and has more than doubled since its March 2020 low. just over half of its pre-financial crisis peak. Yet the benchmark’s gain masks a large variation; the commodities most likely to be purchased by retail investors, such as gold and silver, are among the laggards.
In reality, retail investors are unlikely to ride the Russian-induced natural gas price spike or wade into the London Metal Exchange to battle Chinese tycoons in the short term – and just as well, being given the volatility to the stomach that commodity futures can display.
The most obvious avenue for retail buyers is resource company stocks, although returns here are less promising. According to the Man/Duke study, no individual equity sector offers significant protection against high and rising inflation, with even energy stocks producing only marginally positive real returns. (Exchange-traded funds provide more targeted exposure.)
What about stock markets outside the US, where valuations are less stretched and policymakers may be less determined to drive prices down? The return of inflation follows a long period of post-crisis outperformance for US equities. Judging by price-earnings ratios, the MSCI World ex-US index is at its lowest level against the S&P 500 since the global financial crisis. The MSCI Emerging Markets Index is close to this point. If this is a regime change for the markets, as many believe, it may be time for this trend to reverse.
It’s probably not that simple. For one, inflation is a global phenomenon, so few, if any, markets are spared. Additionally, the speed and extent of any US retreat will affect the outlook. Emerging markets, in particular, have tended to do well when US equities stagnate and investors seek higher yields elsewhere. If US markets fall, beware. Any significant break to the downside would for sure reverberate. This is without even taking into account the destabilizing impact of sanctions against Russia and the worsening Covid epidemic which is hurting an already slowing Chinese economy.
That leaves more esoteric choices. Bitcoin has its supporters, although it has too short a history and too high volatility to be considered a safe inflation hedge. There are also collectibles such as art, wine, and stamps. The Man/Duke study found that these performed well during periods of US inflation, with real annual returns of between 5% and 9%. Maybe it’s worth thinking about. At least if that doesn’t work out, you’ll have something nice to watch while inflation eats away at your portfolio’s value.