There are plenty of inflation-protection tools, but not too many that truly deliver the goods.
This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article is by John Eckstein, chief investment officer and director of research at Astor Investment Management.
Many of our clients are concerned about a rise in inflation. So, I thought I’d take a hard look at various supposed inflation hedges.
We will find that the lowly Treasury bill, the least sexy asset on the planet, is in some ways the best addition as an inflation hedge. So here’s to the reliability of ETFs such as the SPDR Barclays 1-3 Month T-Bill ETF (BIL | A-62).
Plenty Of Options, Plenty Of Doubts
But there are plenty more that are worth looking at.
So those looking for a more dramatic addition to their portfolios than BIL, such as a commodity index, will also get some support, while gold bugs may be disappointed by the metal’s actual inflation-hedging ability. I’ll even take a brief side tour into Japan’s experience with deflation.
The chart below shows inflation as defined by the Consumer Price Index (CPI) from 1950 to date. The eye is drawn to the inflation of the 1970s, wrung out of the system by Federal Reserve Chairman Paul Volcker in the early 1980s.
Inflation has been more tame since, averaging about 2.4 percent per year over the past 20 years. While the Fed used to maintain what I thought was a constructive ambiguity about how it defined price stability, in 2012 it officially announced a 2 percent inflation target—giving investors an explicit anchor for expectations and a benchmark for the central bank.
We do have a bit of a data problem. The lack of sustained, high inflation in the developed markets since the mid-1980s has been good news for consumers. But it’s bad for this article—bad because there has been an explosion of investable inflation-hedging instruments over the past 20 years, but no real good bouts of inflation by which we can judge them.
Where is this constraint binding? Unfortunately, in many of the most interesting assets. Neither oil nor gold prices were market based in 1970—the beginning of the most recent major inflationary period. The REIT index—the best way to think about real estate as a hedge—only goes back to 1972. U.S. inflation-indexed bonds only began trading in the 1990s.
This problem is even more severe when we consider our particular corner of the investment universe: ETFs. These are still in a phase of exuberant growth in the breadth of instruments on offer. So we’ll use a mixture of common sense and research of analogous instruments in the past to determine which ETFs to add to a portfolio.
What We Want In Inflation Hedges
What do we mean when we talk about protecting from inflation? One thing you could do is just look at asset returns adjusted for inflation over the long run. What you’ll find is that whatever does the best in nominal—that is, unadjusted for inflation—terms will also do the best in real terms adjusted for inflation.
As is well known, during most long periods in the United States, stocks perform better than other asset classes. So, in an uninteresting sense and over a long enough period, stocks could be your inflation hedge.
We can see this in the following two charts. The first one covers a long period of fewer assets: 1954-2014, incorporating all of the inflationary 1970s. The second one covers a shorter period of more assets: 1978-2014. They both show that whatever asset has returned the most over the period in nominal terms will usually return the most in real terms as well.
Returns Correlated To Inflation
When we think a bit more precisely about what we can add to a portfolio for a limited period of time to hedge against inflation when we are particularly concerned, we’re saying we want an asset that will experience a large positive return when inflation increases. That’s another way of saying we want to own assets with returns that have a high correlation to inflation.
In a related sense, we might be interested in highlighting those assets that might do particularly poorly during a sustained inflationary period.
So, how does inflation affect the markets? The primary effect on assets is that increases in expected inflation and its volatility—that is, how unpredictable inflation is—both tend to push real rates up. Since nominal interest rates are real rates plus expected inflation, an uncertainty causing spike in inflation is a double whammy to assets.
The following chart shows the average quarterly correlation to inflation of several assets that are either commonly in portfolios or often touted as inflation hedges. Bonds fare the worst, while T-bills do the best. Let's discuss each asset and appropriate vehicles in turn.
Inflation is rightly considered to be the scourge of bonds, and the longer the maturity of the bond, the worse it is.
Long-term ETF bonds reflected in such funds as the iShares 20+ Year Treasury Bond ETF (TLT | A-85) or the iShares 7-10 Year Treasury Bond ETF (IEF | A-58) have a negative correlation to monthly inflation. In other words, you can expect to lose capital because of price declines and have the real value of your portfolio be eroded by inflation too.
In the event of higher inflation, a Treasury bond portfolio is about the worst thing you could have, and you should therefore consider reducing the duration of your portfolio. Daring investors might want to investigate inverse Treasury funds such as the Direxion Daily 20 Year Plus Treasury Bear 3x ETF (TMV). But it is difficult to be profitable when you’re short the bond market and, moreover, short positions as well as exposure with leveraged products require meticulous risk control.
TIPS – Inflation Protected Bonds
Missing from the chart—because of their short history—are Treasury inflation-protected securities, or TIPS. These are bonds issued by the U.S. Treasury whose principal—that is, their final payments—increase with inflation as measured by the CPI. By law, they will hold their value no matter the level of inflation. Somewhat counterintuitively, however, there is not strong correlation between TIPS prices and inflation.
Columbia professor Andrew Ang points out in his book, “Asset Management: A Systematic Approach to Factor Investing,” that the problem with TIPS as an addition to a portfolio is that they are dependent upon real yields.
“As inflation increases, real yields tend to fall. As a result, a TIPS portfolio of new and seasoned bonds of different maturities tends to decline in value when inflation rises,” Ang writes.
You can take measure of this phenomenon by observing that the total returns of many TIPS are lower in the past two years as negative real rates slowly get worked out of the system as the economy slowly recovers. My conclusion is that adding a bit of TIPS to a portfolio to protect it from inflation, while intuitive, won’t work that well.
TIPS are well represented in the ETF world by funds like the iShares TIPS Bond ETF (TIP | A-99) and the FlexShares iBoxx 3-Year Target Duration TIPS ETF (TDTT | A-46).
Given the damage inflation does to 10-year bonds and the disappointing performance of inflation-protected bonds, we might be inclined to forget about the fixed-income market altogether. But that would be a mistake, as short-term fixed-income instruments offer some of the best protection against inflation.
While the prices of T-bills decline as inflation surprises materialize, the pain is short lived, as the U.S. Treasury offers new bills in weekly auctions at new higher yields. In other words, you’re only behind the curve for a limited period of time.
Given that U.S. Treasury bills are basically the definition of “risk free,” our best advice to those worried about inflation is to reduce long-duration assets such as conventional bonds or stocks, and shift that capital into bills, such as those included in funds such as the iShares Short Treasury Bond ETF (SHV | A-97) or the SPDR Barclays 1-3 Month T-Bill ETF (BIL | A-62) for as long as the fear lasts. The forgone returns should be thought of as the price one is paying for insurance.
The GSCI has had good returns over its life, and it does have a fairly strong correlation with rates of inflation. That said, I feel investors need to be well educated and selective about commodity investments.
About half the commodity returns in the GSCI over the long term are due to the T-bill returns incorporated in the futures positions that make up the index, not from the unique characteristics of commodities. Furthermore, the composition of the index in the 1970s was mainly agricultural commodities such as wheat and corn, not the overwhelming majority of energy such as we see today.
While you could argue that, together with the good inflation characteristics of bills we discussed above, commodities have a chance of producing a good return in inflationary times, the high volatility of the market requires constant monitoring, and I think it should mainly be used by professional—or at least extremely diligent—investors.
For commodity investing, at Astor, we prefer the PowerShares DB funds because of their awareness of some subtleties in taking positions, so if I wanted to express an inflation theme with a futures-based commodity ETF, I would likely choose the multicommodity-focused PowerShares DB Commodity Tracking Fund (DBC | B-86) or the energy-focused PowerShares DB Energy Fund (DBE | C-100).
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.
The Deflation Specter
While inflation is the perpetual worry of investors, many observers today think that the risk is still that prices will decline in absolute level; in other words, that the U.S. could experience deflation. This was the Fed’s worry for much of the 2008-2013 period, and European policymakers share that worry today. Why are falling prices bad? The usual answer is the interplay of debt and deflation.
Deflation is when the price of everything decreases. If the price of everything is decreasing, the price the debtors are paid for their labor—their wage—is decreasing. At the same time, the debt contracted by the debtor has not changed in value, so the debtor must spend less on other things to keep current on payments.
When these two facets of deflation are coupled, debtors typically have little room for fiscal maneuvering, and the resulting contractionary impact on an economy can be large.
Japan has struggled with falling prices for much of the past 20 years, so it could offer some hints as to how to position a portfolio in the event deflation becomes a problem in the U.S. I took the deflationary period to be the end of 1998 to the middle of 2012, before the current Prime Minister Shinzo Abe—the anti-deflation crusader—consolidated the leadership of his party. The chart below shows total nominal returns over this 13-year period.
The fixed-income world is the mirror of what we found when looking at inflation, which is to say the bond market has the highest returns, and the T-bill market breaks even.
Riskier assets, such as stocks and property, suffered major declines over this long period. The preliminary lesson I draw from Japan’s experience is that long-maturity bonds are the best hedge in a portfolio against deflation.
Sometimes the best tools are the oldest tools.
After looking at the data and thinking about the issues, I think the best shifts to make to a portfolio if you are afraid of an inflation spike is to cut long-term bonds and perhaps even stocks and add very short-term bills. As short-term interest rates increase, the returns will help weather the volatility on core stock holdings.
Astor Investment Management is a money manager with an active and economically grounded approach to asset allocation. We believe that investment opportunities arise based on the ability to identify fundamental trends and changes in the economy. We build portfolios of ETFs appropriate for our analysis of the business and monetary policy cycles. For more information, see www.astorim.com; for our blog, see www.astorinsights.com.