Financial markets anticipate some inflation and factor it into the prices of the assets they set, a theoretically neutral situation for investment portfolios. On the other hand, unexpected inflation can erode a portfolio’s purchasing power, which is particularly difficult for investors with shorter investment horizons, such as retirees.
As we have seen recently, are some asset classes more resilient than others to unexpected inflation? Commodities stand out as a hedge against unexpected inflation, according to a recent study by Vanguard.
Over the past three decades, commodities have had statistically significant and broadly consistent positive inflation betas, or predicted responses to unit inflation. The study, led by Dr. Sue Wang, associate portfolio manager at Vanguard Quantitative Equity Group, found that commodities have fluctuated widely in inflation betas between 7 and 9 over the past decade. This suggests that a 1% rise in unexpected inflation would lead to a 7% to 9% rise in commodity prices. 1
Commodities have been a solid hedge against inflation
The box shows that the inflation beta of the Bloomberg Commodity Index has been between 7 and 9 over the past decade.
The blue line represents the Bloomberg Commodity Index’s 10-year rolling inflation surprise beta. The shading in the chart reflects the importance of the inflation beta, with darker shading corresponding to greater importance. The significance of inflation beta is a statistical measure determined by the magnitude and volatility of the beta. A larger inflation beta has a larger potential impact as a hedging mechanism.
Vanguard calculations using consumer survey data from Bloomberg and the University of Michigan through March 31, 2021.
Do the other asset classes offer a hedge against inflation? As a simple mathematical fact, the nominal bond is certainly not. “You may not be able to predict the direction of interest rates, but once rates change you know exactly what is happening to your bonds,” she said. Wang explained. “There’s not a lot of uncertainty. Rising inflation leads to higher interest rates and lower bond prices.”
TIPS are primarily intended as a hedge against inflation. But since surprise inflation has a much lower beta (around 1), they would have to significantly increase their portfolio allocations to achieve the same hedging effect as commodities. 2
Discussions of equities as an inflation hedge are more difficult. Our research shows that the hedging power of equities contrasts sharply with that of commodities. “Stocks have a love-hate relationship with unexpected inflation,” Ms. Wang said. This contrast manifests itself in the incoherence of the three different phases of the last three decades.
Broad equity indices are not a consistent hedge against unexpected inflation
This chart depicts three distinct phases of the Russell 3000 Index based on its surprise inflation beta:
The negative beta phase of the post-Volcker era in the 1990s; the high but often negative beta phase after the dot-com collapse of the 2000s; and the positive inflation beta surprise of around 3 to 6.5 in the 2010s.
The blue line represents the 10-year rolling surprise inflation beta for the Russell 3000 Index. significant.
Vanguard calculations using consumer survey data from FTSE Russell and the University of Michigan as of March 31, 2021. Ms. Wang said that the 1990s was a stage of “hate” of love and hate. More than a decade after the Federal Reserve under Paul Volcker raised interest rates to double digits to fight inflation, the Russell 3000 Index, which accounts for about 98% of US stocks, has seen unexpected inflation betas. around minus 9. This means that a 1% rise in unexpected inflation would be equivalent to a 2% fall in the index to 9°.
The inflation surprise beta of the index increased in the 2000s and sometimes turned positive after the dot-com crash. In the low growth, low inflation era of the 2010s, markets decided that a little inflation was not a bad thing, and the unexpected inflation beta turned positive and remained unchanged. “Any sign of inflation after the global financial crisis is a positive signal for the stock market,” Wang said. Beta has been positive but has weakened in recent years, suggesting that markets are less concerned about the impact of inflation on returns over the next few years.
The Vanguard study also found that the hedging power of US equities may decline going forward because commodity-related sectors, including energy and materials, make up a much smaller share of the stock market, while sectors such as technology and consumer discretionary – not effective inflation hedges – over 30 years ago.
Unexpected inflation and portfolio considerations
Vanguard Investment Strategy Group’s asset allocation team takes into account unexpected inflation, along with many other portfolio return factors, when maximizing the capabilities of the Vanguard Asset Allocation Model (VAAM ).
Other Vanguard research introduces a new approach to building high-income portfolios that achieve targeted returns. The team could also turn its attention to targeting unexpected inflation betas, said Todd Schlanger, senior investment strategist and lead author of the forthcoming study.
VAAM leverages Vanguard’s proprietary forecasting tool, the Vanguard Capital Markets Model®, to optimize portfolios based on investors’ risk appetite. “Often, model portfolios are constructed in an ad-hoc and sub-optimal way,” says Schlanger says. Unfortunately, he says, this approach can replace portfolio construction best practices used in model-based solutions like VAAM, which are more systematic.
An unexpected inflation method could take thousands of potential portfolios and rank them according to their inflation betas, filtering out those that don’t meet the criteria, sir. Schlanger said. This will allow VAAM to determine the optimal allocation of asset classes, such as commodities, against the portfolio’s unexpected inflation beta, while considering total return and portfolio diversification, it said. -he declares.
Wang pointed out that portfolio considerations relate to unexpected inflation, not inflation already priced into asset prices by the market, and the idea is to hedge inflation, not fight it. Investors whose goal is to beat inflation will not worry about a possible erosion of purchasing power in the medium term, she said. Instead, they must have a long-term investment horizon.