What Does Rising Inflation mean for Stock Investors?

With inflation on the rise in recent months, stock market investors have used the wisdom of the street to find hedges or protections in commodities, REITs, or real estate mutual funds, as well as stocks and mutual funds. But while those asset classes hedge against energy inflation, they do not hedge against underlying inflation, according to a new expert research report from Wharton and the University of Hong Kong titled “Getting to the Core: Inflation Risks Within and Between. asset classes. ”

“The main conclusion of our research is that what is known as core inflation needs to be analyzed separately, excluding food and energy,” said Wharton finance professor Nikolai Roussanov, who co-authored the paper with Xiang Fang and Yang Liu. assistant professors of finance at the University of Hong Kong. “Much of the discussion in the popular press about different asset classes as they relate to inflation tends to overlook this distinction.”

Core inflation tracks the prices of goods and services, including housing, household items and activities, clothing, transportation, healthcare, and recreation. Core inflation indices, along with food and energy inflation, make up the consumer price index or headline inflation. The consumer price index for urban consumers increased 5.4% (before seasonal adjustments) in June 2021, representing the largest 12-month increase in 13 years, according to the latest Labor Department report. Within that, core inflation increased 4.5%, the largest increase in 12 months since November 1991, and energy inflation increased 24.5%; the food index rose 2.4%.

“[The conventional wisdom that] commodity futures, for example, are a good defense against inflation because commodity prices will go up is not necessarily true,” Roussanov said. Commodity futures hedge against energy inflation, “but energy is not always the main component of inflation,” he added. “It so happened that for the last 20 years inflation has been generally moderate and energy, the most volatile part, really jumped. Many inflationary movements have been overshadowed by high energy prices, especially oil, which is the most powerful. ”

“Many inflationary movements have been overshadowed by high energy prices, and oil in particular is the most powerful.” – Nikolai Roussanov

Key Results

“We argue that looking at inflation into core and non-core components (with a particular focus on energy) is important because it sheds new light on the nature of inflation risks,” the article authors said. “First, core 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 limited to energy inflation, while offering little protection against energy inflation. risk of underlying 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 examined returns in seven major asset classes between 1963 and 2019: US stocks, Treasury bills / bonds, agency bonds, corporate bonds, currencies, commodity futures, and REITs. Between 1963 (for stocks and treasury) and 1983 (for energy), the data had different assumptions.

These Were His Main Findings:

The conventional wisdom that stocks, currencies, and commodity futures are real assets is incomplete: they only hedge against energy inflation. A long position in none of these seven asset classes can hedge against underlying inflation.

The cost of hedging against inflation, or the price of these inflationary risks, of aggregate and energy inflation is indistinguishable from zero. However, underlying inflation carries a significant negative price risk. In other words, insuring your portfolio against underlying inflation is potentially costly due to loss of profitability.

Among commodities, precious metals, especially gold, are the most widely accepted assets for preserving value. Gold and platinum have positive core inflation betas (volatility and therefore risk) that are statistically indistinguishable from zero, and are highly hedged against energy inflation. These precious metal futures have relatively low returns and high volatility, so their ability to hedge against underlying inflation risk is far from assured.
New paradigms

The dynamics of inflation have also changed in the wake of the pandemic. “After Covid, underlying inflation or commodity prices have risen in much of the economy, not just in energy costs,” Roussanov said. Higher commodity prices are also driving up costs in other parts of the economy, he added. “Those two components of inflation, core inflation and energy inflation, often don’t mix. But if they do so and they both stand up, they will somehow reinforce each other. ”

Aside from commodities, most other asset classes do not offer “good protection” against core inflation, he added. Markets in general are reviewing assumptions about assets that have so far been considered decent hedges against inflation: cryptocurrencies such as bitcoin, gold and other precious metals, and inflation-protected securities of Treasury bills, or TIPS, whose values are adjusted to the changes. in the consumer price index. Bitcoin prices, for example, have fallen steadily since their peak in March 2021.

“Now we can see that both stocks and bonds are moving in the same direction, which of course increases the risk to an investor’s portfolio.” – Nikolai Roussanov

The relationship between stocks and bonds will also change, according to Roussanov. “Over the past 20 years, [a mix of stocks and bonds] has proven to be a very strong portfolio, as stocks outperform in good times and bonds are more or less safe,” he said. And in bad times, the Fed lowers interest rates so bond yields fall, which is good for bond prices. So while stocks are falling, say in the Great Recession or even March 2020 with Covid, government bond prices actually spiked due to the Fed’s austerity measures, which compensated investors to some degree. point with this type of wallet. ”

“We may see a breakdown in this negative relationship between bonds and stocks,” Roussanov continued. “If we have an increase in inflation, it will be bad for stocks and bad for bonds at the same time.” That new comparison took place around February 2021, “when there were growing concerns about inflation, with bond yields rising and stock prices also starting to skyrocket,” he noted. “This is the paradigm that we may have to get used to. Now we can see that both stocks and bonds are moving in the same direction, which of course increases the risk to an investor’s portfolio. ”

Investor Options

So what are the reliable options for inflation hedging in the current scenario for investors? “Stay seated. There will be very little in that basket from what we have been able to find so far,” Roussanov said. “Some of the precious metals like gold and platinum seem to have some inflation hedging potential. But they are not very reliable. or very strong in the sense that they are quite volatile. ” He noted that while some market watchers see bitcoin or other cryptocurrencies as an option, he and his co-authors refrain from recommending them because their relative flourishing does not provide enough historical data to draw conclusions; he also noted its recent flourishing. price volatility as negative.

However, TIPS is always an option for investors, according to Roussanov, “TIPS provides a reliable [option] for those looking to protect their portfolios against inflation; TIPS are the safe harbor. They are not particularly attractive, they have negative returns precisely because inflation expectations have risen. ”

“If [the current trend] in inflation is transitory and fairly mild, a well-balanced portfolio of some inflation-protected stocks and bonds should do quite well in the short to medium term.” – Nikolai Roussanov

Demand for TIPS has exploded and they generated a record $ 36.3 billion in new investment in the first half of 2021, according to another Wall Street Journal report, citing data from Morningstar. Adjusted for inflation, TIPS rates have remained below 1% for most of the last decade and have turned negative in recent years, with the offset being inflation protection for capital.

Of course, persistently high inflation isn’t necessarily set in stone, and much depends on how the Fed reacts to recent spikes. Federal Reserve Chairman Jerome Powell said in House testimony last week that recent inflation was uncomfortably above the level the central bank is targeting, the Wall Street Journal reported. In June, Powell had noted that he expected inflationary pressures to be transitory, as many goods and services experienced a one-time price increase after the economy reopened, such as air travel and hotel rates, or new and used cars.

“We will have to wait and see if the Fed’s view is correct that this increase in inflation is really transitory, and we will get back to where we were a few years ago,” Roussanov said. “It is certainly not a foregone conclusion that we will see a sustained rise in inflation. I wouldn’t expect anything like what people are worried about: the nightmare scenario of high inflation of the 1970s. I don’t see the conditions for that. ”

Those prospects offer investors hope. “If [the current trend] in inflation is transitory and fairly mild, a balanced portfolio with a balanced mix of inflation-protected stocks and bonds should do quite well in the short to medium term,” Roussanov said. .

Comments are closed.