Exclusively from Gerard Minack’s Downunder Daily:
Inflation corrodes most asset values. It’s harder for investors to protect themselves against high inflation than against deep recession. Investors in developed markets haven’t had to worry about inflation risk for several decades, but now that risk is rising. This note looks at what investments have succeeded in previous periods of high inflation.
Inflation has rarely been a concern for investors in developed markets over the past 30 years. But aggressive fiscal stimulus, backstopped by central banks, is increasing the risk that inflation rises to uncomfortable levels for investors. History suggests that there are fewer places to hide in a high-inflation environment than there is in recession. This note draws heavily on recent research The Best Strategies for Inflationary Times, by Henry Neville, Teun Draaisma, Ben Funnell, Campbell Harvey & Otto Van Hemert. (All the authors are associated with MAN Group. Ben & Teun are old colleagues of mine. The full report, available here, has more detail than I will use now.)
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The first thing to note is that for some markets the impact of inflation can depend on both its level and whether it is rising or falling. For example, equity markets can re-rate when inflation is low if it is also rising – but typically will de-rate when inflation is low if it is also falling (Exhibit 1).
The impact of inflation is straightforward in other markets: rising inflation is typically detrimental for Treasury returns, and typically positive for commodity markets. Exhibit 2 shows the correlation between US equity and bond returns and the change in inflation, sorted by the starting level of inflation. Bond returns are always inversely correlated to inflation, regardless of the inflation rate. The correlation between equity returns and inflation flips depending on the inflation level, and is strong only at inflation extremes (high or low).
As an aside, this explains why the equity-bond correlation can flip. US data suggest the tipping point is CPI inflation around 2½% (Exhibit 3).
The Best Strategies report focusses on when inflation is rising and ultimately peaks at over 5%. For the US there are 8 episodes over the past century – which account for 19% of the period – that satisfy that criteria. (The report also looks at high inflation episodes in the UK and Japan, but here I will focus on the US results.)
Exhibit 4 shows returns, split between the inflationary episodes and all other periods, for major asset classes and equity styles.
A few points about these results:
First, commodities are the stand-out inflation hedge amongst conventional assets. Based on reconstructed returns, trends strategies have also been able to generate positive real returns.
Second, the two major investable asset classes – debt and equity – do badly. Moreover, there is almost nowhere to hide within those asset classes. In debt, TIPS has provided moderate positive returns; in equity, energy stocks have gained.
Third, high and rising inflation dramatically skews relative performance within equities.
Fourth, it’s worth noting that 10 year Treasuries have lost less money than US equities in these inflationary periods. That may be because as inflation peaks Treasuries rally in anticipation of a cycle downswing – while equities may be selling off in anticipation of recession.
But this is consistent with the historical correlation between the equity risk premium and trend inflation (Exhibit 6). In other words, rising inflation does more damage to equity valuations than it does to bond valuations.
My base case is that inflation won’t reach uncomfortable levels in the US until second half of 2022. And it is not my base case that inflation will reach 5%. However, that risk is clearly larger now than it has been for some time, so it is worth considering how to hedge such an outcome.
A few points in riposte:
- Gerard thinks that US growth is strong enough to support commodities despite a rising DXY. I don’t.
- The major reason why is that China is going to slow from H2 as it tightens and as its volumes demand will come off sharply in 2022, especially for bulks.
- For me, therefore, 2022 shapes as a US economic boom and EM market (if not economic) bust not unlike 2015.
This is risky for all asset prices because the Fed will struggle to short circuit downside with easing as it did in 2015.
Therefore, the safest place will be US value stocks where potent growth will still be delivering good profits growth.