The Best Strategies for Inflationary Times

  • Henry Neville, Teun Draaisma, Ben Funnell, Campbell R. Harvey, and Otto Van Hemer
  • Journal of Portfolio Management
  • A version of this paper can be found here
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What are the research questions?

Inflation — what’s that? … It has been quite a while since inflation has been considered a problem. Today, however, the angst surrounding the possibility of a resurgence in inflation is real and “top of mind” for investors.   If the current fear becomes a reality, how should investors react? What strategies and asset classes perform well in a rising inflationary environment? If inflation does resurge beyond a temporary phase, how should investors restructure or reposition their portfolios? The purpose of this article is to provide context for those decisions. 

Defining a high or rising inflationary regime as one with an increase of 5% in year-over-year rates of change, 34 regimes from 1926 to 2021 for the US (Consumer Price Index, CPI), the UK (Retail Price Index, RPI), and Japan (Nationwide CPI) were analyzed and the following 3 topics were addressed.

  1. Which asset classes do well or poorly during high and rising inflationary environments?
  2. Do active approaches do well or poorly during high and rising inflationary environments?
  3. What about cryptocurrencies?

What are the Academic Insights?

  1. The results for the US are presented in Exhibit 2 and ranked by average annualized real returns during 8 regimes occurring in the US.  Here’s what the authors found:
    • Equities performed poorly during inflationary regimes. The expectation is that the rate on debt for stocks should theoretically offer some relief and prices of products can be adjusted upward.  The reality is much different as the risk in costs tends to outpace the risk in product prices.  Further, no equity sector seemed to offer much relief other than energy.  Even at that, real returns to energy were only slightly positive at 1%.
    • As with equities, nominal bonds offered little to no protection during inflationary regimes and any protection provided tended to diminish as the regime became more prolonged. More importantly, the negative correlation between bonds and equities essentially disappeared when inflation began to rise.  This observation presents quite a challenge to the foundations of the 60-40 prescription to which many investors are subscribed. The one exception in the fixed income class was TIPS. They provided robust returns regardless of the inflationary regime.
    • Commodities posted a perfect track record and performing quite well during rising returning an average of 14% over the 8 regimes with each regime being positive.
    • Real estate comes in a far second to commodities but did hold it’s value at a slight negative -2% real return, although it was not significant.
    • Collectibles like wine, art and stamps produced strong returns, around 8% but given their inherent limited capacity are unsuitable to occupy a large portion of institutional portfolios.
  2. YES, IN THE FORM OF FACTOR INVESTING AND TREND FOLLOWING.
    • Active equity factors were examined and generally held their own during inflation regimes. Cross-sectional momentum was best, returning 8% compared to 4% during normal periods.  The difference was not statistically significant however. 
    • Consistent with the notion that inflationary regimes as prolonged periods play to the strength of trend following strategies.  Time-series momentum when applied to futures and forwards across asset classes applied to bond and commodity trends performed quite well at 15% and 20%.  One caveat: although real returns were positive, this result has limited applicability given the inherent minimal capacity for commodities. There is no doubt, however, that the prolonged nature of inflationary regimes plays to the strongest features of trend following.
    • Quality returned a small positive real return of 3% with value returning a small negative return of -1%.  
  3. BE WARY. Cryptocurrencies should be approached cautiously. As a new and disruptive “asset class” cryptocurrencies are indeed interesting, but it is premature to include crypto as an inflation hedge.  Although some argue to the contrary,  bitcoin and US equities are actually positively correlated.  We know that high inflation is negatively related to US equities. Therefore, returns to bitcoin are unlikely to be positive during rising inflation, given their positive correlation with equities.  The math just doesn’t work at this point.  We have only 8 years of data which has been observed over a period of time when inflation was very low.  Even if we accept the hedging premise, the volatility of bitcoin is of such a large magnitude, when compared to the SP500 and gold, it is likely to be an unreliable hedge.

Why does it matter?

The authors of the research summarized here, provide a frame of reference and develop standards for making helpful judgments regarding investing in high inflationary periods. Instead of predicting when and if a rise in inflation may occur, investors may instead evaluate whether or not portfolios should be restructured. If so, more active approaches including factor (quality, value, and momentum) strategies and especially trend following strategies in bond and commodity markets have offered protection to the traditional 60-40 allocation.

The most important chart from the paper

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained.  Indexes are unmanaged and do not reflect management or trading fees, and one cannot invest directly in an index.

Abstract

Over the past three decades, a sustained surge in inflation has been absent in developed markets. As a result, investors face the challenge of having limited experience and no recent data to guide the repositioning of their portfolios in the face of heightened inflation risk. In this article, the authors provide some insight by analyzing both passive and active strategies across a variety of asset classes for the United States, the United Kingdom, and Japan over the past 95 years. Unexpected inflation is bad news for traditional assets, such as bonds and equities, with local inflation having the greatest effect. Commodities have positive returns during inflation surges, but there is considerable variation within the commodity complex. Among the active strategies, the authors find that trend-following provides the most reliable protection during important inflation shocks. Active equity factor strategies also provide some degree of hedging ability. The authors also provide an analysis of alternative asset classes such as fine art and discuss the economic rationale for including cryptocurrencies as part of a strategy to protect against inflation.

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