Stocks & Bonds
- Stock returns, during periods of high inflation, have been quite poor. If you take annual stock and bond returns from 1900 through 2020 for 21 countries in the DMS database and sort them into percentiles based on each country’s contemporaneous inflation rate for that year, you can see pretty clearly that when inflation is at its highest, stock returns take a pretty significant hit. It should be noted, however, that, over long periods of time, stock returns have outpaced inflation by a pretty wide margin.
- In market volatility when stocks drop, bonds tend to be pretty good at helping to protect that downside but bond returns, under high inflation, are riskier on the downside than stocks based on historical data.
- government inflation protected bonds respond to changes in inflation (in the U.S. they are called TIPS and in Canada, they are called real return bonds)
- they adjust their principal to inflation every six months but
- they are only an obvious hedge against unexpected inflation if the bond matches your investment horizon. For example, if you say you have a $100,000 expense in 20 years, you can buy an inflation protected bond maturing in 20 years and you are then guaranteed to maintain your purchasing power, plus the real yield on the bond at the end of the 20 year period.
- Unfortunately, however, there is a lot of uncertainty about the short term real return on a long-term inflation protective bond because, just like any other long bond, there can be a lot of meaningful short-term price volatility that overwhelms changes in inflation and, therefore, it is not necessarily a hedge. You could use short-dated inflation protected bonds to get around the duration issue and the bond price volatility issue but, in doing so, you are betting on inflation being higher than the market currently expect.
- short-term nominal fixed income like cash. When I say cash, people might think that’s the worst thing to hold during a period of high inflation but that is only true if you’ve got dollar bills sitting under your mattress, but short-term debt and cash earn interest when they’re sitting there.
- If one country has high inflation, another country’s stock market is not necessarily going to have poor performance in that time period. For example, if Canada has high inflation, Italy’s stock market is not going to be necessarily affected by Canada’s high inflation.
- Diversifying internationally against inflation levels and inflation changes is more effective than domestic equities but it doesn’t mean they’re a perfect hedge. You’ve still got the volatility.
- I don’t think that there is a perfect hedge against unexpected inflation. It doesn’t exist. Inflation protected bonds are the only true hedge, but only if they perfectly match your investment horizon.
- Long dated inflation protected bonds are probably too volatile to be a hedge in the short term against unexpected inflation, and short-term inflation protected bonds, which get around the duration issue have negative real yields right now so short-term real bonds are probably not the answer either.
- Short term nominal fixed income and cash have historically responded quite well to inflation because rates have typically increased. Can we bet on that happening again in the same way in the future? I don’t know so, I wouldn’t call it a hedge, and do you really want a zero real return?
- Gold doesn’t check any of the boxes. It’s not an inflation hedge in the short-run or the long-run.
- International stocks are too volatile to be considered a hedge, but they definitely provide diversification benefits, especially in the event that high domestic inflation happens, where domestic stocks will tend to do poorly.
- There’s some weak evidence that value stocks have tended to perform well relative to growth stocks during periods of increasing interest rates, which can be related to inflation, but it’s not enough evidence to call it an inflation hedge by any means but, that being said, value stocks like international stocks offer a positive expected return independent of the domestic market. Well, I don’t know if international is necessarily independent of the domestic market, but it’s definitely another source of expected returns.
The more sources of expected return that you can have in a portfolio – small value stocks, value stocks, domestic equities, international equities, maybe fixed income – the greater the chances that your portfolio will not have a zero real return for an extended period of time.
Building a diversified portfolio is the ultimate inflation hedge and that’s probably the best way to deal with expected and unexpected inflation. That’s not actually an inflation hedge. It’s just a way to deal with it.
A Few Last Words:
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