Inflation hedge

Inflation is wreaking havoc with invested wealth. Except for commodities, all major asset classes – ranging from U.S. leveraged loans to emerging market equities – have lost money so far this year. Investors are scrambling to protect their assets against the ravages of rising prices. They will have to restructure their portfolios to adapt to this change of regime. The trouble is that even traditional inflation hedges have proved disappointing.

For more than a quarter of a century, investors benefited from low and stable inflation. Price stability meant more predictable corporate earnings. Lower interest rates fed through to higher equity and bond valuations.

It’s no secret that fixed-income securities perform poorly when inflation is rising rapidly. So-called bond vigilantes demand extra compensation for holding these obligations, so yields rise and prices come down. By the end of the so-called Great Inflation of the 1970s, U.S. Treasury bonds had lost so much money in real terms they were dubbed “certificates of guaranteed confiscation”.

Equities, which are claims on real assets, provide protection from inflation over the long run. But in shorter time frames stock market valuations tend to decline as bond yields rise. When inflation last took off between 1966 and 1981, the ratio of price to earnings of U.S. equities halved.

For the past couple of decades, conventional investment portfolios benefited from the fact that bonds and stocks moved in opposite directions over short periods. When the stock market declined, long-term interest rates would fall, thereby boosting bond prices. A benchmark investment portfolio with 60 percent allocated to equities and a 40 percent weighting in bonds delivered fabulous returns.

But when inflation takes off, stocks and bonds become positively correlated, rising and falling together. In the first half of the 1970s, a classic 60-40 portfolio in UK stocks and bonds lost more than half of its value in real terms. In the first six months of this year, the same portfolio declined 16 percent in nominal terms.

The failure of bonds and stocks to deliver protection when inflation spikes has forced investors to seek other hedges. Property is the ultimate real asset. But the value of bricks and mortar doesn’t always increase in line with prices. In hard times, governments often impose rent controls, while landlords face higher mortgage costs. This year, residential property markets around the world are suffering as interest rates rise. U.S. real estate investment trusts were down 19% in the first six months of the year.

Gold has been a store of wealth for millennia. During the decade of the Great Inflation, the yellow metal appreciated by around 1,400%. For most of that time, the price of gold moved inversely with the stock market, providing investors with the diversification that bonds no longer afforded.

This year, however, the barbarous relic has fallen around 10% in dollar terms. Gold bugs are not too dismayed: the recent poor performance is largely a consequence of the steep rise of the greenback. Gold has delivered positive returns when measured in euros, yen and British pounds.

Still, many investors won’t touch gold because it generates no income and is difficult to value. Besides, it’s proven to be an extremely volatile inflation hedge in the past, forming bubbles when investors lose confidence in paper assets and collapsing in value when the inflation cycle turns down.

Industrial commodities are another alternative to paper assets, but they are also volatile and exposed to industrial downturns. Copper went through two boom-bust cycles in the 1970s. History is repeating itself. Last year copper rose 26 percent as inflation picked up, but so far this year it has given back all its gains.

By the end of the 1970s, after a decade of dismal performance from bonds and equities, there was no shortage of advice on how to hedge investments. The authors of “Inflation-Proofing Your Investments”, published in 1981, recommended that portfolios have 40 percent in gold and silver, and just 5 percent in long-dated bonds and 15 percent in stock market investments. This turned out to be terrible advice. Over the next few decades, stocks and bonds soared while gold entered a long bear market.

“Each attempted inflation hedge has its particular attractions, risks, and shortcomings,” wrote the journalist Henry Hazlitt in 1978. That’s true of real estate, gold and commodities. But inflation-protected bonds, whose principal and interest are linked to an index of prices, weren’t around at the time. The UK government introduced index-linked gilts in 1981, while the United States first offered Treasury Inflation Protected securities (TIPs) in 1997.

In theory these securities should protect investors from rising prices. This year, however, index-linked bonds have proved one of the worst inflation hedges. Some long-dated UK index-linked gilts have crashed, and even 10-year TIPs are down more than 10% so far this year. These losses occurred because bond yields adjusted to the new world of higher interest rates from a starting point of extreme overvaluation.

The real yield on 10-year TIPs has climbed from minus 1 percent in January to around 1.6 percent today. That yield is now roughly in line with recent growth in U.S. productivity – a loose proxy for the TIPs’ fair value. By contrast, the real yield on conventional 10-year Treasuries is currently minus 4 percent. Investors expect inflation will average 2.5 percent over the next decade, only a little above the Federal Reserve’s target.

Hazlitt wrote that the only reliable inflation hedge is to end inflation. That may be true. But inflation-protected bonds at positive real yields are the next best thing. If the Fed loses its battle against rising prices, more people will come to appreciate the insurance they provide. Prudent investors should replace their conventional Treasuries with TIPs. A decent real yield and protection against unexpected inflation should help them sleep easier at night.