Myth-Busting: Equities Are an Inflation Hedge


I grew old and studied economics in the 1970s and I remember what a terrible period it was. . . . Nobody wants this to happen again.– Janet Yellen


Inflation continues to dominate the investment conversation in 2021. Many countries have made a strong comeback from the COVID-19 crisis and are experiencing higher-than-expected inflation. The annual inflation rate in the United States rose to 5% in May 2021, the highest level since August 2008.

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While inflation is an evergreen topic for investors, it has gained prominence ever since central banks implemented their aggressive monetary policies during the global financial crisis. Although inflation has been on a downward trend since the 1980s, printing all that money has fueled inflationary trends. Some have even warned about possible hyperinflation reminiscent of that seen in the Weimar Republic of the 1920s.

Investor Survey 2021: What is the best way to hedge against inflation?

Chart showing Investor Survey 2021: What's the best way to hedge against inflation?
Source: JP Morgan, Factor Research

Whether the current higher readings are temporary or structural, how can investors hedge against inflation risk? According to a recent survey of quantitative investors at the JPMorgan conference, 47% of respondents believe that commodities are the most effective protection against inflation, followed by equities (27%), rate products and Treasury inflation-protected securities (TIPS). , 10%). and other devices (17%).

The case for commodities like precious metals is clear. Less so for equities: Since operating businesses can increase prices at will, the theory holds, they can mitigate the negative effects of high inflation by simply raising their prices along with it.

Does the data support this argument? Is Equity an Inflation Hedge?

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A Look at US Inflation

The average annual US inflation rate between 1947 and 2021 was 3.4%. It went down from only 0% about 15% of the time and went over 10% of the time only 7% of the time. For 57% of the time, it was between 0% and 5% and about 20% between 5% and 10%.

For most investors in today’s developed markets, their only experience of high inflation is through the history books. Although it is often discussed, few traders have direct experience of the havoc wreaking havoc on the economy and financial markets.

US annual inflation

Chart showing US annual inflation
Source: FRED, Factor Research

Equity Returns in Various Inflation Regimes

We created four inflation patterns for the period 1947 to 2021 using inflation data and stock market data from the St. Louis Federal Reserve Kenneth R. french data library.

The average monthly equity return was comparable across these different environments. The lowest returns occurred during periods of deflation, which usually coincide with an economic downturn. However, inflation above 10% did not have a negative impact on stock market returns.

Monthly US Equity Return by Inflation Regime, 1947 to 2021

Chart showing monthly US equity returns from the inflation regime, 1947 to 2021
SOURCES: FRED, Kenneth R. French Data Library, Factor Research

Actual vs Nominal Returns

Of course, analyzing returns without correcting for inflation is a simple but frequent mistake. A savings account with a 2% interest rate is attractive enough when inflation is 0%, but not so much when it is 3% and means a negative real interest rate.

A comparison of the nominal and actual monthly equity returns across the four inflationary regimes gives a very different perspective. In real terms, inflation above 5% sharply reduced returns, while inflation above 10% essentially made the stock unattractive.

Perhaps the real return is still positive and so the equities hedged against inflation. Nevertheless, stocks are volatile instruments and the average return hides the dramatic decline that has occurred over 70 years.

Actual Monthly US Equity Return by Inflation Regime, 1947 to 2021

Chart showing actual monthly US equity returns from the inflation regime, 1947 to 2021
SOURCES: FRED, Kenneth R. French Data Library, Factor Research

inflation losers

So which sectors suffered the most during the high inflation regime? Kenneth R. Our analysis of 30 sectors covered by the French Data Library found that when inflation exceeded 10%, the worst-affected sectors were those that dealt directly with consumers – consumer goods, autos, retail, etc. Despite their ability to adjust prices at will, these businesses seem to struggle to pass the increase on to their customers.

A current disclosure of this is the European financial services industry. Banks have been hesitant to charge negative interest rates on their retail savings accounts, but still accuse asset managers and other institutional clients of negative rates on deposits.

Real monthly US equity returns: 10 worst sectors amid high inflation, 1947 to 2021

Chart showing actual monthly US equity returns: 10 worst sectors amid high inflation, 1947 to 2021
SOURCES: FRED, Kenneth R. French Data Library, Factor Research

inflation winner

The same sectors did not perform equally poorly when inflation hovered between 5% and 10%. Some even gave positive returns. In contrast, the sectors that benefited most from high inflation were roughly the same during the two high inflation regimes: in particular, energy and materials, which investors often rely on to position equity portfolios for high inflation.

Real Monthly US Equity Returns: 10 Best Sectors Amid High Inflation, 1947 to 2021

SOURCES: FRED, Kenneth R. French Data Library, Factor Research

While it confirms the inflation-hedging properties of the usual suspects, it also has some caveats. The two high-inflation regimes occurred mostly during the 1970s, when US inflation reached 23.6%. Inflation was hit by the rise in oil prices due to OPEC sanctions. The price of WTI crude rose from $4 a barrel in 1973 to over $10 in 1974, and then to $40 in 1980.

Oil prices are likely to remain volatile amid geopolitical turmoil and could theoretically push prices to new highs. But the world is reducing its reliance on fossil fuels and the US fracking industry has helped increase supply. So while the energy sector has historically been a good bet against inflation, this trend may not continue any further.

So what if we remove the boom and bust in the oil price cycle and exclude the period from 1973 to 1986 from our analysis? The same 10 sectors still perform well amid a high inflation regime driven by oil prices.

Real Monthly US Equity Returns: The 10 Best Sectors Except for the 1973 to 1986 Oil Crisis

SOURCES: FRED, Kenneth R. French Data Library, Factor Research

further thoughts

Although some equity sectors exhibited inflation-hedging characteristics, this data is of little practical value. To be useful, it would require market-timing skills. Furthermore, such stocks are commodity proxies, so if investors can predict inflation, they would probably be better served by having direct commodity exposure.

And the matter of keeping the commodities is complicated. The Goldman Sachs Commodity Index (GSCI) trades today about where it did in 1990. Such a situation would be unbearable for most investors. Betting on commodities is a bet against human progress: it likely proposes long-term harm.

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A more interesting inflation hedge might be investing in trend-following, commodity-focused funds, or commodity trading advisors (CTAs). If high inflation causes oil or gold prices to rise, these funds will sooner or later jump on the trend. If prices fall amid a fall in inflation, investors can short these asset classes. Naturally, this strategy won’t work perfectly all the time – the last 10 years are reminiscent of that – but it can be a more elegant way of hedging against both inflation and deflation.

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All posts are the views of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of the CFA Institute or the author’s employer.

Image Credits: © Getty Images/JupiterImages

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Nicholas Rabner

Nicolas Rabner is the Managing Director of Factor Research, which provides quantitative solutions for factor investing. Previously he founded Jackdaw Capital, a quantitative investment manager focused on equity market neutral strategies. Prior to this, Rabner worked at GIC (Government of Singapore Investment Corporation), which focused on real estate across asset classes. He began his career working for Citigroup in investment banking in London and New York. Rabner holds an MS in Management from the HHL Leipzig Graduate School of Management, is a CAIA charter holder, and enjoys endurance sports (100 km ultramarathon, Mont Blanc, Mount Kilimanjaro).

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