The search for havens from the worst inflation in four decades feels like it’s about to get a lot more real. The bad news is that the task isn’t looking at all easy or straightforward, at least for individual investors whose choices are confined to the standard asset classes and who rely on a traditional 60-40 portfolio mix of equities and bonds to weather the ups and downs of market cycles. If US policymakers follow through on their aggressive tightening rhetoric, we could be in for some testing times.
The upsurge in US consumer prices has long passed the point at which it could be considered temporary, yet the stock market has remained remarkably resilient. The benchmark S&P 500 was less than 6% off January’s record high as of Friday’s close. The trouble for investors betting that markets will ride out this bout of 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 markets remain buoyant, the higher the Fed may have to raise interest rates to achieve the desired result.
How should investors respond then? One of the most downloaded papers over the past 12 months on the SSRN academic research site is titled “The Best Strategies for Inflationary Times.” The study, by researchers from hedge fund firm Man Group Plc and Duke University, makes for uncomfortable reading. Drawing on almost a century of data for the US, UK and Japan, it concludes that equities and bonds both perform poorly during inflationary times. The annualized real return on US stocks averaged -7% during eight such periods since World War II. Real estate doesn’t offer much of a refuge: It also provides negative real returns, though not of significant magnitude. The one major asset class that reliably outperforms when inflation is high and rising is commodities, with a real return averaging an annualized 14%.
This was a propitious and very useful observation — in March 2021, when the paper was first published. The problem is that commodities have been going gangbusters for months, so those just waking up to the severity of last week’s Fed language may already have missed the boat. The Bloomberg Commodity Index has risen 48% in the past year and has more than doubled since its March 2020 low. Arguably, the commodities rally could have much further to run, with the index still standing at little more than half of its pre-financial crisis high. Still, the benchmark’s gain masks wide variation; the commodities most likely to be bought by retail investors, such as gold and silver, are among the laggards.
In reality, small investors aren’t likely to be surfing the Russia-driven surge in natural gas prices or wading into the London Metal Exchange to do battle with short-squeezed Chinese tycoons — and just as well, given the stomach-churning volatility that commodity futures contracts can display. The more obvious avenue for retail buyers is the stocks of resources companies, though the returns here are less promising. No individual equity sector offers significant protection against high and rising inflation, according to the Man/Duke study, with even energy stocks yielding only slightly positive real returns. (Exchange-traded funds do offer more targeted exposure.)
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What of stock markets outside the US, where valuations are less stretched and policy makers may be less intent on bringing prices down? The return of inflation follows a long period of post-crisis outperformance for US equities. Judged by price-earnings ratios, the MSCI World Excluding United States Index is at its cheapest relative to the S&P 500 since the global financial crisis. MSCI’s emerging markets index is close to that point. If this is a regime change for markets, as many believe, perhaps it’s time for that trend to reverse.
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It’s probably not that simple. For one thing, inflation is a global phenomenon, so few if any markets are untouched. Moreover, the speed and magnitude of any US retreat will affect the outlook. Emerging markets, in particular, have tended to do well when US stocks stagnate and investors go looking for higher returns elsewhere. If American markets plunge, though, watch out. Any significant downward break would be sure to reverberate. That’s without even considering the destabilizing impact of sanctions against Russia and a worsening Covid outbreak that’s hurting an already-slowing Chinese economy.
That leaves more esoteric choices. Bitcoin has its advocates, though has too short a history and too high a volatility to be considered a safe inflation hedge. There are also collectibles such as art, wine and stamps. The Man/Duke study discovered these performed well during US inflationary periods, with real annual returns of between 5% and 9%.
Maybe that’s worth thinking about. At least if it doesn’t work out, you’ll have something nice to look at while inflation eats away the value of your portfolio.