One of the key risks facing investors is the risk of inflation. Thus, when constructing a portfolio, the correlation of investments in it to inflation should play a role in the asset allocation decision. In a May 2015 study, “Facts and Fantasies about Commodity Futures Ten Years Later,” authors Geetesh Bhardwaj, Gary Gorton and Geert Rouwenhorst presented the historical evidence surrounding correlations.
The following table, adapted from the study, shows the correlation of inflation to equities (as represented by the S&P 500 Index), nominal-return bonds (as represented by long-term U.S. government bonds) and an equally weighted commodity futures index.
Correlations Of Assets With Inflation (July 1959 - December 2014)
Note: Correlations are based on overlapping monthly returns data
The key takeaways from the data are:
- While many investors believe that stocks are a good inflation hedge, the evidence shows that the correlation of stock returns to inflation is actually slightly negative. Thus, while stocks do provide an expected risk premium, they are not a good hedge against the risks of inflation.
- As should be expected, the correlation of returns between nominal bonds and inflation is also negative. In fact, it’s more negative than the correlation between stocks and inflation.
- The correlation between the returns of commodity futures and inflation is positive, and the positive correlation is more pronounced over longer time horizons.
Given that the correlation of stock returns to inflation is negative (while it’s positive for commodities and inflation), the data indicate commodities offer a better hedge against inflation than stocks.
The data also suggest that commodities offer a hedge against the term risk of long-term bonds. And in fact, from July 1970 through June 2015, the annual correlation of the return on long-term Treasury bonds and the S&P GSCI was -0.18.
An investment that acts as a hedge against unexpected inflation might be a condition for investors to consider adding asset classes to their portfolios, but that characteristic alone doesn’t represent a sufficient condition.
Other factors, such as implementation costs, tax efficiency, expected returns, volatility and correlation with other asset classes, should also be considered.
With that caveat, if one is considering adding an allocation to commodities because of their diversification benefits (in addition to their negative correlation with nominal bonds, the annual correlation of returns between the S&P 500 and the S&P GSCI was 0), one might also consider adding some incremental term risk (assuming there is a positive term premium).
That would allow an investor to earn the incremental term premium while adding a hedge against term risk. Similarly, if investors are considering adding term risk to earn a term premium, they might also consider adding an allocation to commodities to act as a hedge against that incremental term risk.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.