Mixed Record Of Inflation Hedges

October 06, 2014


Gold’s reputation as an inflation hedge is not entirely deserved. The real return of physical gold, for which the gold bullion ETF, SPDR Gold Shares (GLD |A-100), is intended to be a proxy, comes in at fifth place on our list of effective inflation-fighting assets. That’s below bond over the period studied.

In addition, gold has only a modest positive correlation to quarterly inflation. Whatever it is doing in your portfolio, there’s not much evidence that it will be a great inflation hedge.

Stocks & REITs

In ancient times, the 1960s, finance professors believed that stocks should be a good inflation hedge because they represent ownership in real assets, such as factories, and the profits they will produce. Then came the so-called great inflation of the 1970s, and U.S. equities, as measured by the S&P 500 Index, produced about zero real return with substantial volatility and eye-watering drawdowns over that period.

The current consensus, as described in the paper Inflation Hedging for Long-Term Investors by Attie and Roache, is that stocks are a better long-run inflation hedge than they are in the short run. So, according to our criteria above, stocks tend not to have a high short-run correlation to inflation, but may recover values over longer periods.

If we think of the dividend discount model of stocks, this makes sense. As inflation increases, returns demanded throughout the financial system increase, meaning that to purchase an asset today, new investors demand a higher expected return. When you first hear “returns to increase,” it sounds good. But then you realize that the way to increase expected return and lure in new buyers is to lower the price.

If you already own the asset, higher expected returns in the hazy future may be cold comfort. But over long periods, stocks are calls on the productive capacity of real assets, so they should eventually recover from inflation.

REITs (well represented by such ETFs as the Vanguard REIT ETF (VNQ | A-88) and the iShares U.S. Real Estate ETF (IYR | B-93), have similar patterns as stocks, with slightly higher returns over our period, as well as a slightly higher correlation to inflation.


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