Investing for Inflation, Part II

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This is part 3 of my thoughts on investing in inflationary times (see Reggie Middleton's Take on Investing for Inflation, pt. 1 and Reggie Middleton's Take on Investing for Inflation, pt. 2). I had my team run independent verification of inflation correlated asset performance, for it appears to me that many investors tend to simply follow what they have heard others say versus looking into what the facts are. In the process of the investigation, we have tracked the performance of asset classes discussed on my blog, including all maturities of treasury, inflation linked treasury, municipal bonds, residential mortgage, other metals and agricultural commodities. We have also computed nominal returns (based on a 255 trading day convention), real returns, asset volatility and Sharpe ratio for each the asset classes across time periods to determine performance of each asset class over a period of time. Below is the summary charts and tables of our findings. (Pro subscribers, please refer to the attached excel document for detailed information for each time period - Q2 2009 Asset Inflation Correlation Datasheet 2009-06-12 14:21:51 2.47 Mb)

Agriculture commodities: Historically, agricultural stocks have not provided sufficient hedge against inflation because of a lack of storability and more or less constant demand (which is not linked directly to level of economic activity, unlike other commodities). Also, due to supply shocks, agricultural commodities have one of the highest volatilities (in terms of standard deviation) and lowest Sharpe ratio. In addition, agriculture commodities have low correlation with inflation, negative real returns (in almost all sub-periods) and low nominal returns.

Emerging markets, real estate and Gold offer one of the highest real returns in that order. However, lower volatility of commercial real estate sector makes this sector one of the most attractive in terms of risk-reward ratio. Within commercial real estate, apartments have one of the highest real returns (after emerging markets) and highest Sharpe ratio amongst all asset class.

	Nominal Return	Real Return	Standard deviation	Sharpe ratio	Correlation
Commodities
Precious Metals
Gold	6.1%	3.0%	19.6%	0.16	0.68
Silver	3.9%	0.8%	30.8%	0.03	0.23
Non-ferrous metals
Copper	3.7%	0.6%	28.4%	0.03	0.46
Aluminum	-0.7%	-3.8%	24.4%	(0.15)	0.24
Lead	4.1%	1.0%	25.8%	0.04	0.57
Nickel	5.7%	2.6%	41.7%	0.06	0.52
Tin	1.3%	-1.8%	21.5%	(0.08)	0.61
Steel	0.3%	-2.8%	16.4%	(0.17)	0.39
Zinc	-0.5%	-3.6%	24.2%	(0.14)	0.46
Agriculture commodities
Live Cattle	1.8%	-1.3%	19.6%	(0.06)	0.88
Livestock	1.3%	-1.8%	19.2%	(0.09)	0.73
Sugar	1.0%	-2.2%	40.2%	(0.05)	(0.31)
Heat Oil	0.5%	-2.6%	33.4%	(0.07)	0.65
Lean Hogs	0.3%	-2.8%	31.1%	(0.09)	(0.19)
Coffee	0.3%	-2.8%	37.4%	(0.07)	(0.37)
Cocoa	0.1%	-3.0%	28.8%	(0.10)	0.09
Cotton	-0.6%	-3.7%	28.5%	(0.12)	(0.36)
Soybean	2.8%	-0.3%	30.1%	(0.01)	0.37
Wheat	2.6%	-0.5%	25.9%	(0.01)	0.33
Grains	2.6%	-0.6%	22.9%	(0.02)	0.34
Corn	2.3%	-0.8%	25.7%	(0.03)	0.31
Energy
WTI Crude	2.1%	-1.0%	34.3%	(0.03)	0.64
Real Estate Sector
Residential real estate
Residential (S&P Case Shiller)	2.8%	-0.3%	3.1%	(0.06)	0.87
Commercial real estate - Total Return (price + income)
NCREIF Property Index	6.5%	3.3%	4.2%	0.81	0.89
NCREIF Property Index - Apartment	7.4%	4.3%	4.3%	1.03	0.90
NCREIF Property Index - Industrial	6.7%	3.6%	4.2%	0.89	0.89
NCREIF Property Index - Retail	6.7%	3.6%	3.8%	0.98	0.88
NCREIF Property Index - Office	6.0%	2.9%	5.7%	0.52	0.87
Commercial real estate - Price return
Commercial Price Index	3.2%	0.1%	7.8%	0.03	0.94
Apartment Price Index	4.0%	0.9%	8.7%	0.11	0.96
Industrial Price Index	2.9%	-0.2%	10.1%	(0.01)	0.95
Retail Price Index	3.0%	-0.1%	8.4%	0.00	0.92
Office Price Index	4.0%	0.9%	8.2%	0.13	0.93
Equities
Domestic Equities
S&P 500	3.9%	0.8%	15.8%	0.06	0.00
Global Equities
MSCI World Index	4.7%	1.5%	15.3%	0.11	0.84
Emerging Markets
MSCI BRIC EM Index	4.8%	1.7%			0.75
Brazil	24.6%	21.5%	48.6%	0.45	0.92
China	4.7%	1.6%	44.3%	0.04	0.58
Russia	13.8%	10.7%	56.5%	0.19	0.79
India	11.7%	8.6%	29.0%	0.30	0.84
JPM Morgan Emerging Market Debt Fund	-2.5%	-5.6%			(0.25)

Treasury yields have declined significantly over a period of time. Except during the 1970s (during high inflation) treasury yields have declined over the past 3 decades and currently are at an all time low (please refer to the chart below). High inflation coupled with economic recovery could cause yields to increase.

	Change in yield
Fixed Income	2000's	1990's	1980's	1970's	Correlation
Treasury Bonds
Short Term
Yield on Treasury (1-month)	(357)	n/a	n/a	n/a	0.64
Yield on Treasury (3-month)	(534)	(254)	(504)	n/a	0.63
Yield on Treasury (6-month)	(541)	(228)	(609)	n/a	0.63
Yield on Treasury (1-yr)	(557)	(208)	(434)	651	0.81
Intermediate Term
Yield on Treasury (2-yr)	(551)	(199)	(372)	433	0.76
Yield on Treasury (3-yr)	(517)	(199)	(311)	247	0.66
Yield on Treasury (5-yr)	(472)	(193)	(299)	359	0.71
Yield on Treasury (7-yr)	(423)	(182)	(292)	269	0.61
Yield on Treasury (10-yr)	(373)	(193)	(296)	300	0.68
Long Term
Yield on Treasury (20-yr)	(302)	62	(337)	254	0.66
Yield on Treasury (30-yr)	(287)	(191)	(270)	237
Inflation Adjusted Bonds
Inflation-indexed Treasury (5-yr)	(54)	n/a	n/a	n/a	(0.19)
Inflation-indexed Treasury (7-yr)	(81)	n/a	n/a	n/a	(0.26)
Inflation-indexed Treasury (10-yr)	(72)	n/a	n/a	n/a	(0.53)
Inflation-indexed Treasury (10-yr)	222	n/a	n/a	n/a	(0.83)
Municipal Bonds
20 yr Municipal Bond	(130)	(115)	(37)	59	0.43
Corporate Bonds
Investment Grade Corporate Bonds Yield (AAA)	(239)	(144)	(223)	283	0.56
High Yield Corporate Bonds Yield (BAA)	6	(175)	(260)	320	0.55
Mortgage Bonds
30-yr, Fixed-Rate Conventional Home Mortgage	(340)	(199)	(314)	559	0.60
International Bonds
S&P/Citigroup International Treasury Bond Index Ex-U.S.	(143)	n/a	n/a	n/a	0.17
Euro Govt Bond 10-15 yr	(167)	n/a	n/a	n/a	(0.07)
India Sovereign Zero Coupon Yield 10 Year	(479)	(86)	n/a	n/a	0.25
USD Brazil Sovereign Zero Coupon Yield 10 Year	(774)	128	n/a	n/a	(0.16)
USD- Euro Russia Sovereign 10 yr	(1,076)	n/a	n/a	n/a	(0.69)

Comments

[jjmagoo:]

I find this writer's lack of familiarity with the English language a monumental barrier to understanding what the hell he is talking about.

Jun 16 07:55 PM

[Tom Colangelo:]

Reggie,

Thank you for the information and hard work.

It is a welcome relief from the moronic posts that are sometimes found in these blogs.

Very interesting that emerg mkts came out on top.

Since they live off of our spending, how do they show better returns that their U.S. customers?

Won't they be lagging our recovery since bond funds they need will be soaked up by the U.S. and other mature economies looking to fund their stimulus programs?

Thanks.

Jun 16 08:27 PM

[Speedspirit:]

Carefull what you percieve as inflation investments that may make you money when we very well could be in a deflationary state. And from here we could go straight to hyper inflation. So did your team think about that scenario? Did your team consider all the market manipulation that has taken place? Emerging markets are either dependent on the US for exports or thier invested interest in the dollar so if we fail they fail, the saying is "The New World Order" because thats what it is. In and out thats the trade.

Jun 16 10:04 PM

[mountain view:]

Magoo:

I may only be a humble carpenter (and a one-time grammar teacher), but Middleton's writing is plenty clear. Oh, he might miss a comma or an article, or an "s" here or there, but on balance he gets his point across quite well. More important, he nailed the collapse (or share-price implosion) of more than one financial or real estate giant, encouraging followers to short, when the likes of Dick Bove were writing the epitaph of the financial crisis, and others were pasting "buy" signs on stocks that would plummet in the fall of "08.

Read Reg's website, and you might appreciate his intelligence, versus trumping up a charge of poor writing.

Mountain Man


On Jun 16 07:55 PM jjmagoo wrote:

> I find this writer's lack of familiarity with the English language
> a monumental barrier to understanding what the hell he is talking
> about.

Jun 16 10:48 PM

[punk_ash:]

Right on. USD may just be the best investment show in town. Who knows.


On Jun 16 10:04 PM Speedspirit wrote:

> Carefull what you percieve as inflation investments that may make
> you money when we very well could be in a deflationary state. And
> from here we could go straight to hyper inflation. So did your team
> think about that scenario? Did your team consider all the market
> manipulation that has taken place? Emerging markets are either dependent
> on the US for exports or thier invested interest in the dollar so
> if we fail they fail, the saying is "The New World Order" because
> thats what it is. In and out thats the trade.

Jun 17 02:21 AM

[cynewulf:]

Is this part 3 or part II ?

Jun 17 01:45 PM

[foxburrow:]

What time period are we talking about above? The past ten years?

Jun 18 09:11 AM