Allocations for inflation (part 5): a tale of three asset classes
As John Roe highlighted in his blog in this series, we believe clients shouldn't lose sight of their overall investment objectives, and accurately define how they relate to inflation. Most growth investors seek returns that keep pace with inflation in the long term, but others may have more direct inflation-linked liabilities. In this blog, I explain the differences between hedging inflation, keeping pace with inflation, and having the chance of a great return should inflation spike. I illustrate with three asset classes: UK linkers, equities, and commodities.
Linkers – the best inflation hedge?
Suppose a UK investor has an inflation-linked objective over a 20-year period. What is the best hedge for that objective?
The answer is a (zero-coupon) linker that matures in 20 years. This is as true for a personal investor through their defined contribution (DC) pot or personal portfolio, an endowment fund, or a defined benefit (DB) scheme. The economics is the same. This doesn’t mean a linker is what you necessarily should invest in (this blog is not an advert for linkers!), but - when it comes to hedging inflation - it wins.
The reason a linker is the best hedge is that the return it achieves over that time horizon is (almost) perfectly correlated* with the increase in UK prices over the same period. It may not ‘keep up’ with your inflation-linked objective - indeed, you are guaranteed a loss in real terms - but that just reflects that investors can’t control real interest rates, and how pitiful they currently are!
Overseas inflation-linked securities such as US TIPS may help hedge a pickup in global inflation (and may offer better value), but are not as good a hedge against UK inflation as UK linkers.
Equities – tend to keep up with inflation, but not a hedge
You’re probably thinking this is all very well from a technical perspective, but not necessarily what a ‘long-term investor’ should care about. Isn’t ‘keeping up with inflation’ what matters? Isn’t tilting into equities (or other high expected return assets) the answer to higher inflation?
Equities form a core component of growth strategies. But evidence their returns are directly linked to, or heavily influenced by, inflation is mixed at best. To suggest they hedge inflation effectively over any time horizon is therefore a stretch. What we can say is that equities tend to keep pace with inflation, but this is due to the high reward investors get for taking equity risk – i.e. the equity risk premium. Indeed, take enough rewarded risk anywhere and you can expect to keep up with anything you like – you could ‘expect’ to retire a billionaire. But this misses the huge risk, of course!
It is very tempting to take more risk to defy the pitiful real yields that investors now face. However, this isn’t necessarily a good idea. An unhedged increase in inflation, for example, is arguably a sunk loss in terms of prospective outcomes. In general, the right reaction to a sunk loss is to re-anchor expectations.
Commodities – the high-inflation-beta asset class
It’s sometimes claimed commodities are the best inflation hedge in the short term, but this isn’t strictly right either; historically, the correlation of their returns with inflation surprises is moderate**. A short-dated linker is a better hedge. However, because they are such a volatile asset class, even a modest correlation with inflation means that the asset class has a high inflation sensitivity or beta*** and so will tend to outperform when inflation spikes. This can be useful for investors who cannot use leverage in their portfolios, such as DC schemes, who normally can’t or won’t use DB-like liabilty driven investment (LDI) strategies such as levered exposure to linkers, or inflation swaps to hedge inflation risk.
But much like linkers, commodities typically make for a poor long-term store of value, with low historic and prospective risk-adjusted returns. As such, we believe only very modest strategic allocations make sense in many portfolios.
UK linkers offer the ultimate hedge against UK inflation, provided they line up with the investment horizon. However, they may not be ideal for leverage-constrained investors targeting higher returns or investors who have a strong view that they are overpriced.
Equities may help you to keep pace with inflation but come with added risk. Are you falling for a sunk-cost fallacy?
Commodity returns are moderately correlated to inflation surprises and have high inflation beta due to high volatility, which may pay off when there are high inflation surprises. However, they have low expected returns (so are less likely to keep pace with inflation than growth assets) and are not as reliable a hedge as linkers.
- In the first blog in this series, Chris Teschmacher introduced the problem with inflation for multi-asset investors.
- In the second, John Roe analysed the key questions for managing inflation in a multi-asset portfolio.
- In the third, Chris Jeffery looked at the implications for fixed income.
- In the fourth, Willem Klijnstra considered the role of currencies.
* Assuming the UK government doesn’t default and ignoring some minor complications due to lags.
** Around 50% but it varies with choices such as which index, which historic period, etc.
*** Beta is effectively a combination of correlation and relative volatility.