Index Investor's  Instablog

In response to the global recession, money supply growth rates are now at record levels in many parts of the world, which has significantly raised the chances of higher inflation in the years ahead.  A number of recent research papers have re-examined the inflation hedging properties of different asset classes, and we will summarize their key findings here.

In “Inflation Hedging for Long-Term Investors”, Attie and Roache of the IMF begin with two important distinctions: first, between the one year and longer term response of nominal asset class returns to an increase in inflation, and second, between an increase in expected inflation and an unexpected increase in inflation.  From our perspective, for a long-term investor, the key issue is the evolution of longer term asset class returns to both expected and unexpected increases in inflation.

The IMF paper focuses on U.S. markets (where data availability is best) and examines the inflation hedging properties of cash (i.e., short term government securities), nominal return government bonds, equities, commodities and gold. They also include two SDR weighted indices of global equity and global government bonds (i.e., these country weights are proportionate to the weights of different currencies in the Special Drawing Rights basket).  Let’s start with the twelve month change in returns on different asset classes (between 1973 and 2008) in response to a one percent increase in the rate of inflation (i.e., the short-term response).  The IMF finds that the two best hedges were commodities (a 9.87% increase in the GSCI index) and gold (a 6.87% increase).  Cash was next best, with a fall of 57 basis points, followed by short term foreign bonds with a fall of 69 basis points.  In contrast, domestic equities fell by (2.59%), global equities by (3.48%), domestic government bonds (all maturities) by (1.33%) and global bonds (all maturities) by (2.36%).

However, for long-term investors, the one year return response to a rise in inflation is less important than the five year response.  As the IMF notes, “inflation shocks persist...After one year, the cumulative increase in price level is nearly three times the size of an initial shock, and after five years this has risen to five times.”  Hence, the long-run return response of different asset classes is critical.  To capture this, the IMF calculates a long-run return multiplier, which essentially measures the extent to which the effects of an inflation shock are offset by a rise in nominal asset class returns.  A multiplier of 1.0 signifies that the inflation shock is completely offset by higher asset class returns; greater than 1.0 signifies more than offset, and less than 1.0 (or negative) signifies a failure to fully offset the effects of inflation.

Short term Treasuries have a long-run multiplier of .8.  Bonds suffer sharp relative declines in the short-run, but after a trough at three years begin to offset earlier losses through increases in yields relative to inflation, leading to a multiplier of .1.  Equities show the worst performance, with a multiplier of (.2).  Commodities are a more interesting case, with the strong short term response offset after about two years by a decline in economic activity (and commodity demand) triggered by higher inflation. As a result, their long-term multiplier is, like equities, (.2).  The IMF paper does not present a longer term analysis of the gold multiplier.

Finally, two methodology points should be kept in mind about this study.  First, as the authors acknowledge, the data it uses covers a period (1973-2008) when a number of structural breaks have occurred in the underlying economic series and return generating processes for some asset classes.  Hence, the study’s conclusions are at best rough estimates.  This view is further reinforced by the second methodology observation, that some of the study’s methodology assumes normally distributed returns. While this makes the math tractable, it is at odds with actual distributions which have fatter tails (i..e, a greater portion of extreme returns).

Two other asset classes that are traditionally viewed as good inflation hedges are absent from the IMF study: real return (inflation-indexed) bonds, and commercial property. Two studies find that, in both the U.S. and U.K, inflation indexed bonds provide good hedges against inflation: “Diversification Benefits of Treasury Inflation Protected Securities: An Empirical Puzzle” by Mamun and Visaltanachoti” and “Asset Allocation with Inflation Protected Bonds” by Kothari and Shanken.  However, neither study takes the IMF approach, and examines the long-term multiplier effect following an inflation shock.  However, the IMF does raise the interesting point that historically, a rise in inflation has been associated with a longer-term rise in realized (ex-post) real interest rates, due to a sharp increase in the inflation risk premium required by investors in nominal bonds. However, they make no mention of whether this also applies to ex-ante real rates (indeed, if the real interest rate rise is all due to higher inflation risk premia, then ex-ante real yields would remain flat or decline).  This is an important consideration for investors in inflation protected bonds, since a fall in real yields would boost their returns, while a rise in real yields would cause them to decline over the longer-run.  On balance, given the decline in real economic activity associated with rising inflation, we think it most likely that ex-ante (expected) real yields – which drive inflation protected bond pricing -- would decline (raising returns on this asset class), and that any increase in realized real returns on nominal government bonds is driven by an overestimation of the inflation risk premium relative to the rate of inflation that later occurs.

The inflation hedging benefits of commercial property is a far more interesting issue. First, it is complicated by data and market issues affecting both exchange traded and directly owned commercial property. These are sufficiently complicated that they will be the subject of a longer article in next month’s issue. Second, the hedging benefits of commercial property also has a significant time-lag component. In the short-term, property rents are generally fixed (though revenue related retail rents and similar structures are an exception).  However, as leases come up for renewal, they tend to catch up with inflation – though the extent of the catch up can be offset by the decline in economic activity caused by inflation.  These issues are examined in another paper, “The Inflation Hedging Characteristics of US and UK Investments: A Multi-Factor Error Correction Approach” by Hoesli, Lizieri and MacGregor.  In the short-run, the authors find little adjustment to an inflation shock; however, in the long-run, they find that in both the US and the UK property returns recover most (but not all) of the ground they lost – to put it in the terms used by the IMF, the multiplier is positive, but less than 1.0.

Last but not least, also absent from the IMF study is any discussion of timber as an inflation hedge.  We would expect it to perform in a manner similar to commercial property.  In the short term, timber producers’ earnings and returns might decline following a rise in inflation, assuming costs rose faster than revenues earned on fixed price contracts.  However, given the continuing (and completely uncorrelated) biological growth of timber, as well as the renegotiation of contract prices over time, we would expect timber to have a five year inflation multiplier close to 1.0 (though still below it because of rising inflation’s negative impact on aggregate demand growth).

So, to sum up: in the short-term, inflation-protected bonds, commodities and gold appear to be the best inflation hedges.  Not far behind are short-term domestic and foreign government securities (with the performance of the latter driven by the difference between home country inflation and average inflation in major foreign bond markets).  In the medium term, inflation protected bonds and short-term bonds continue to do well.  We suspect this also applies to gold and timber. Commodities, however, lose some of their hedging benefits if higher inflation leads to lower real economic activity. On the other hand, as is well described in another new paper (“The Three Epochs of Oil” by Dvir and Rogoff), declining demand can be more than offset by changing commodity supply conditions, as happened in 1973 and 1979 – so the medium term decline in commodities’ inflation hedging benefits is not automatic, and in fact may not occur.  Finally, any long-term decline in commodities returns may be offset by better long-term hedging performance in commercial property, where adjustments to higher inflation only occur over time.

Postscript: IndexIQ has recently registered with the U.S. SEC a new ETF that will track US CPI inflation.  Assuming reasonable pricing and tracking errors, this should also be an excellent inflation hedging instrument when it is launched.

Tom Coyne
 Chief Investment Strategist

Disclosure: No Positions