What rising inflation means for equity investors


With inflation on the rise in recent months, stock investors have used the wisdom of the street to find hedges, or protection, in commodities, REITs or real estate investment trusts, as well as in stocks and mutual funds. But while these asset classes provide hedges against energy inflation, they do not offer hedges against core inflation, according to a new research paper from experts from Wharton and the University of Hong Kong. titled “Getting to the Core: Inflation Risks Within and Across Asset Classes. “

“The main takeaway from our research is that you need to look at what is called core inflation separately, excluding food and energy,” said Wharton finance professor Nikolai Roussanov. , co-author of the article with Xiang Fang and Yang Liu, both assistant professors of finance at the University of Hong Kong. “Much of the discussion in the popular press about different asset classes in their relationship to inflation tends to miss this distinction.”

Core inflation tracks the prices of goods and services, including housing, furnishings and operations, clothing, transportation, health care, and recreation. Core inflation indices, along with those for food and energy inflation, make up the consumer price index, or headline inflation. The consumer price index for urban consumers in June 2021 rose 5.4% (before seasonal adjustments), the largest 12-month increase in 13 years, according to the latest report from the Ministry of Labor. . As part of this, core inflation rose 4.5%, the largest 12-month increase since November 1991, and energy inflation rose 24.5%; the food index increased by 2.4%.

“[Conventional wisdom that] Commodity futures, for example, are a good hedge against inflation because commodity prices will rise is not necessarily true, ”said Roussanov. Commodity futures provide a hedge against energy inflation, “but energy is not always the major component of inflation,” he added. “It turns out that over the past 20 years inflation has been largely contained and energy, its most volatile part, has really stood out. Many inflationary movements have been masked by high energy prices, oil in particular being the most powerful. “

“A lot of the inflationary moves have been masked by high energy prices, oil in particular being the most powerful.” –Nikolai Roussanov

Main conclusions

“We argue that it is important to break inflation down into core and non-core components (with a particular focus on energy) as it sheds new light on the nature of inflation risks,” said the authors of the article. “First, core inflation and energy inflation have very different statistical and economic properties. Second, the inflation-hedging properties of conventional “real assets”, such as stocks, currencies, and commodity futures, are largely confined to energy inflation, when they are not. offer almost no protection against the risk of core inflation. Third, core inflation carries a significantly negative price of risk, while the price of risk associated with energy inflation is in most cases indistinguishable from zero.

In their study, the authors looked at the returns of seven major asset classes between 1963 and 2019: U.S. stocks, treasury bills / bonds, agency bonds, corporate bonds, currencies, commodity futures, and REIT. The data had varying starting points between 1963 (for stocks and Treasury bills) and 1983 (for energy).

Here are their main findings:

  • The misconception that stocks, currencies and commodity futures are real assets is incomplete: they only hedge energy inflation. A long position in any of these seven asset classes cannot hedge against core inflation.
  • The cost of hedging against inflation – or the price of those inflation risks – of headline and energy inflation is indistinguishable from zero. However, core inflation carries a significant negative price of risk. In other words, insuring your portfolio against core inflation is potentially costly because of the shortfall.
  • Among commodities, precious metals, especially gold, are the most accepted assets for preserving value. Gold and Platinum have positive core inflation betas (volatility and therefore risk) that are statistically indistinguishable from zero and they hedge strongly against energy inflation. These precious metal futures have relatively low yields and high volatility, so their ability to hedge against the risk of underlying inflation is far from assured.

New paradigms

The dynamics of inflation also changed in the aftermath of the pandemic. “After Covid, core inflation or the prices of goods have increased in large swathes of the economy, not just energy costs,” said Roussanov. Rising commodity prices are also pushing up costs elsewhere in the economy, he added. “These two components of inflation – core inflation and energy inflation – often do not go hand in hand. But when they do and they both stand up, they’re going to kind of reinforce each other. “

Apart from commodities, most other asset classes “also do not offer good protection” against core inflation, he added. Around the world, markets are revising assumptions about assets that were until then considered decent hedges against inflation – cryptocurrencies like bitcoin, gold and other precious metals, and securities of the Treasury Inflation-Protected Treasury, or TIPS, whose values ​​are adjusted for changes in the Consumer Price Index. Bitcoin prices, for example, have been falling steadily since their peak in March 2021.

“Now we could actually see that stocks and bonds will go in the same direction, which of course magnifies the risk for an investor’s portfolio.” –Nikolai Roussanov

The relationship between stocks and bonds is also expected to change, according to Roussanov. “Over the past 20 years, [a combination of stocks and bonds] has turned out to be a very strong portfolio because in good times stocks outperform and bonds are more or less secure, ”he said. “And in tough times, the Fed cuts interest rates so bond yields go down, which is good for bond prices. So even if stocks fall, say during the Great Recession or even in March 2020 with Covid, Treasury bond prices have actually risen because of the Fed cuts, which have offset investors to some extent with this. type of wallets. “

“We could see a break in this negative relationship between bonds and stocks,” Roussanov continued. “When we have a pickup in inflation, it will be bad for stocks, and it will be bad for bonds at the same time.” This new equation played out around February 2021, “when there was this growing concern about inflation, with bond yields rising and stock prices also starting to crack,” he noted. “This is the paradigm we should potentially get used to. Now we could actually see that stocks and bonds will go in the same direction, which of course magnifies the risk for an investor’s portfolio.

Options for investors

So what are the reliable inflation hedging options in the current scenario for investors? “Don’t move. There will be very little in this basket as far as we have been able to find so far,” said Roussanov. “Some precious metals such as gold and platinum seem to have some potential for hedging against inflation. But they are not very reliable or very strong in the sense that they are quite volatile. ”He noted that although bitcoin or other cryptocurrencies are considered by some market watchers to be a option, he and his co-authors refrain from recommending them because their relative origin does not offer enough historical data to make inferences; he also pointed out that their recent price volatility was negative.

TIPS, however, are still an option for investors, according to Roussanov, “TIPS offers a [option] for those who want to protect their portfolios against inflation; ADVICE is the safe haven. They are not particularly attractive – they have negative returns precisely because inflation expectations have increased.

“Yes [the current trend] if inflation is transient and moderate enough, a well-balanced portfolio that contains a number of inflation-protected stocks and bonds should do reasonably well in the short to medium term. –Nikolai Roussanov

Demand for TIPS increased and they attracted a record $ 36.3 billion in new investment in the first half of 2021, another the Wall Street newspaper according to the report, citing data from Morningstar. After adjusting for inflation, TIPS rates have been moving below 1% for most of the last decade and have turned negative in recent years, with the tradeoff being inflation protection for the principal amount.

Of course, continued high inflation is not necessarily set in stone and depends a lot on the Fed’s reaction to recent spikes. Federal Reserve Chairman Jerome Powell said last week in House testimony that recent inflation was uncomfortably above the levels sought by the central bank, the the Wall Street newspaper reported. In June, Powell noted that he expected inflationary pressures to be transient as many goods and services saw one-off price increases after the economy reopened, such as air travel and airline fares. hotels, or new and used cars.

“We’ll have to wait and see if the Fed’s opinion is correct that this pick-up in inflation is really transitory, and we’ll get back to where we were a few years ago,” Roussanov said. “It is certainly not a given that we are going to see a continued upturn in inflation. I wouldn’t expect anything close to what people are worried about – the nightmare scenario of the 1970s with high inflation. I do not see the conditions for this.

This prospect offers hope to investors. “Yes [the current trend] inflation is transient and fairly moderate, a well-balanced portfolio that has a well-balanced mix of inflation-protected stocks and bonds should perform reasonably well for the near to medium-term future, ”said Roussanov.

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