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Beating inflation versus hedging against inflation

Beating inflation means outpacing prices, as illustrated by an image of a track athlete.

Signs of higher inflation abound. Beating inflation to preserve spending power is therefore high in many investors’ minds.

Bank of England chief economist Andy Haldane chimed in just this week, reports Reuters:

“If wages and prices begin a game of leapfrog, we will get the sort of wage-price spiral familiar from the 1970s and 1980s,” Haldane said, adding that inflation would not be on the same scale as in those decades.

In an interview with LBC radio earlier on Wednesday, Haldane said inflation pressure in Britain was looking “pretty punchy”.

9 June 2021, Reuters

Of course, predictions of higher inflation rival England’s football team for hype versus reality.

Surging inflation and English football glory have both been notably absent for many decades.

Inflation’s coming home

Indeed, one way to preserve the real value of your pound would have been to bet against England at every major tournament in my lifetime.

You’d probably have multiplied your initial stake nicely by betting that way – and reinvesting the proceeds each time.1

Betting against England might be a way of beating inflation.

However nobody sensible would say betting for or against England was a way of hedging against inflation.

While I haven’t earned a PhD crunching the numbers, England’s footballing performance surely has no correlation with inflation.

A sports team – and hence your bet – will win or lose irrespective of the inflation rate, in other words.

Whereas a hedge against inflation would be expected to protect against a decline in the spending power of your money due to rising prices.

Multiplying money via a wager – and so getting more spending power, beating inflation – doesn’t mean you actually hedged against inflation.

Beating inflation with a Banksy

So far so obvious – albeit dispiriting for England fans.

Yet the same confusion between beating inflation and hedging against inflation appears often in the investment world.

Right now asset managers are marketing their products as inflation hedges.

Here’s an advert I saw on Facebook under the banner: “Want a hedge against inflation? Invest in art today.”

Inflated expectations

Who wouldn’t want a 16,347% return over 13 years? Sign me up!

Actually, not so fast.

On these numbers, this (unnamed) piece of art would have been a fabulous investment.

But the advert tells us nothing about whether art is good for hedging against inflation, as opposed to beating inflation.

True, the 16,347% return equates to almost 50% a year on a simple annualized basis. Unless you’re getting clobbered hyperinflation, a 50% return a year will surely do a good job of beating inflation.

It would also turn anyone with a few paintings in their attic into multi-millionaires.

But I’m highly skeptical that anyone should expect a typical piece of art to go up in value near-50% a year over the next 13 years.

Annual returns around the 7-8% range from art are more typical what I’ve seen touted.

Yet even if your art choice did so well, I’d congratulate you on your luck or a great eye – but not necessarily on your choice of an inflation hedge.

At least not just because its price went up a lot.

To view art as an inflation hedge, we’d need a thesis as to why art should hedge against inflation (easy – real assets tend to go up over time, with inflation) and data showing correlation (I’ve never seen that for art).

Equities have a record of beating inflation

What about shares? Many people – me included – tend to think of equities as protecting against inflation.

We have our reasons. Companies can lift prices in response to inflationary pressure. They often own real assets such as land and property. Over time profits and dividends can rise – in contrast to bonds with fixed coupons. All of this means share prices can rise in the face of higher inflation.

However the authors of the Credit Suisse Equity Yearbook refute this notion.

The renowned academics divided equity and bond returns into buckets representing different inflationary regimes – from marked deflation through stable prices to very high inflation – as follows:

Source: Elroy Dimson, Paul Marsh, and Mike Staunton, Credit Suisse EY 2021

Their work shows the return from bonds varies inversely with inflation. At times of deflation (left-hand side) bonds do very well. They get smashed by high inflation (right-hand side).

Equities do much better than bonds most of the time – the exception being times of extreme deflation.

But real returns from equities are negative with very high inflation, although they still beat bonds.

We can’t really call equities an inflation hedge then. Not when their real return falls with high inflation!

The professors note:

These results suggest that the correlation between real equity returns and inflation is negative.

i.e. equities have been a poor hedge against inflation.

There is extensive literature which backs this up. Fama and Schwert (1977), Fama (1981), and Boudoukh and Richardson (1993) are the three classic papers.

Credit Suisse Equity Yearbook, 2021

If this fact is so accepted in academic circles, why do we think of owning equities in the face of rising inflation?

It’s because the returns from equities have a strong record of beating inflation over the long-term.

Shares do not hedge against inflation. But the magnitude of their out-performance versus other assets means over many decades and cycles they’ve typically delivered the best returns, easily beating inflation.

What assets really hedge against inflation?

Generally you want to own real assets – ‘stuff’ – when inflation takes off, if you want to hedge against inflation.

After all, inflation in part expresses how the price of stuff is changing.2

The following from Bank of America (via Trustnet) shows such correlations:

Source: Bank of America

Most things are positively correlated to inflation over the long-term.

Even cash! (That’s because interest rates tend to rise as inflation rises.)

The big exception is long-term government bonds. These are negatively correlated.

If inflation heads a lot higher then you’d look at returns from long-term bonds through your fingers. From behind the sofa.

Note the image shows correlations, not past or future returns.

The price of platinum is strongly positively correlated to inflation. That doesn’t mean platinum will necessarily be a brilliant investment.

Picking your poison in 2021

The best hedge against inflation are products designed for that purpose.

Index-linked government bonds, perhaps a basket of inflation-linked corporate bonds, or NS&I index-linked certificates.

However index-linked bonds are very expensive today. They are vulnerable to interest rate rises.

Corporate bonds introduce credit risk.

As for NS&I certificates, they aren’t even available to new investors. They also pay a pathetically low real return to those who already own them.

You’ll be hedged against inflation with NS&I index-linked certificates for sure. But you’re guaranteed to only just beat it…

Beyond that – and set against everything I’ve written above – I believe most of us should concentrate more on beating inflation than hedging against it. For a private investor with real world spending concerns, the long-term outcome is more important than the short-term correlations.

For most of us that means a healthy allocation to assets like equities and property – and crossing our fingers that we don’t face 20 years of stagflation. (You might want to own some gold in case of that).

Given how strongly correlated bonds are to inflation – they will surely do badly when inflation is running hot – you could argue holding fewer in a portfolio is also an effective way to dial down inflation risk.

However the more you reduce your government bonds, the more exposed you are to stock market falls – and also to deflation.

Beating inflation over the long-term

Finally, what do you know about inflation that the market doesn’t? It’s been constant media chatter for months now.

Someone somewhere is always warning of higher inflation.

I first saw that Bank of America forecasting imminent inflation – complete with an earlier version of its correlation image I included above – in the Financial Times in 2016.

And before that, at the start of QE I worried – like most people who didn’t work at the US Federal Reserve – about the inflationary consequences of monetary expansion.

Well it’s been 12 years and we’re still waiting!

Remember, if you’re working your income is likely to rise with inflation. Also if you own a house with a mortgage, over the medium-term inflation will probably push up prices while whittling down the real value of your debt.

Passive investors are probably best mostly sticking to a diversified portfolio, with a mix of assets aimed at beating inflation over the long-term, while also guarding against other scenarios.

If you want to gamble, punt on your national football team!

  1. I’m assuming you’d earn a return on your stake between tournaments. And I haven’t done the maths! But given England hasn’t won anything since the 1960s I’m confident. []
  2. The other part is changes in the price of services. []
{ 12 comments… add one }
  • 1 bloodonthestreets June 10, 2021, 5:12 pm

    With US inflation hitting 5%, I don’t think the financial world can continue “It’s different this time” denial. Inflation is looking concerning, and this is even before Biden’s trillions of spending kicks in. Bonds just don’t seem to function in the same way now they are hovering around zero. It feels like QE has permanently skewed people’s expectations. Could it be that we have a generation of young traders and managers who literally were still at school in the 00s and can’t comprenhend a world economy without QE?

  • 2 c-strong June 10, 2021, 8:41 pm

    @TI – I really like the distinction between beating and hedging against inflation – your conclusion that we should prefer the former is one I had more or less come to myself, without elucidating the difference so clearly.

    As a value-head, I would be remiss not to point out that value stocks have generally outperformed growth stocks during periods of higher inflation. E.g. https://www.evidenceinvestor.com/how-inflation-affects-growth-versus-value/

    @bloodonthestreets – I share your concerns, up to a point, but the 5% rate is misleading as it’s entirely due to the base effect. A better measure is the annualised rate over the last two years, which is 2.6%. There’s a calculator here: https://www.usinflationcalculator.com/ – it annoyingly doesn’t give you the annualised rate but this is easy to calculate (and can be approximated for short periods by dividing by the number of years).

  • 3 Jonathan B June 10, 2021, 10:26 pm

    Thanks @c-strong, I was also going to say that looking at inflation on a 12 month basis is meaningless because of Covid, a realistic estimate can only be made over 2 years. (That is true of everywhere, not just USA).

    But @bloodonthestreets I also wonder (worry) whether QE has reset expectations such that old strategies may not work so well.

  • 4 mr_jetlag June 11, 2021, 11:00 am

    It’s like the old joke about the bear and the two hunters – you don’t have to run faster than the bear to get away. You just have to run faster than the guy next to you…

  • 5 Seeking Fire June 11, 2021, 12:27 pm

    Very interesting article if only to remind the casual observer that slightly counter-intuitively equities are a poor inflation hedge.

    – Experience of Japan in the 1990’s was sky high assets prices and low CPI inflation. Could well be what is happening here
    – 5% inflation rate to at a headline is concerning but I feel given 2020 it’s more relevant to see where we are in 24 months as it can easily drop out (or not…)
    – For sure rate hikes must be last on the agenda list for monetary authorities given consumer sensitivity to interest rates and risk of causing a recession. The treasury must be concerned as to the outside chance that rates in the US increase forcing Gilts to increase thus increasing the % to which tax revenues service interest forcing tax hikes and public sector cuts. Not likely but the UK is quite exposed to this notwithstanding much of its debt is financing LT I understand. Kind of a joke that the only economic policy we seem to have is stoking a housing boom (twas ever thus)
    – There are a lot of deflationary forces still out there – technology, working from home (lower salaries), also debt is deflationary – you take on a bigger mortgage to service your new house you’ve bought and have less money to spend on products and services
    – FWIW (nothing) I feel official inflation measures will settle down in 12 months time – the ketchup bottle is being shaken but we’re not spurting out just yet
    – How to invest on the above basis. I continue to buy global equities, $TIPS, gold but am thinking around farm land, forrest, additional buy to let (there are some areas near London where prices are lower than they were 12 months ago due to Brexit and CV) and borrowing some money at a low rate to fund as an inflation hedge. Don’t know yet

  • 6 159F June 11, 2021, 4:11 pm

    I was recently reviewing my Vanguard Lifestrategy holding exactly with inflation in mind. Not a lot of genuine comfort within Lifestrategy in this respect down the (one wonders if that sh(c)ould change) but I decided to hold firm on the LS as it still satisfies my risk objectives but then beef up actively elsewhere to combat a bit of short term inflation. Global equities and a very small punt on gold. Couldn’t stomach the crypto although it wouldn’t surprise me if that isn’t such a dumb move in small doses.

  • 7 Brod June 11, 2021, 6:23 pm

    Which begs the question – how much inflation protection do you need?

    If equities will (generally) beat inflation over the long term, do I need three, five, ten years of inflation hedge? I’ve got a small DB pension and 10% in gold, the DB pension should just about cover food, wine, utilities and council tax. Will that do? I guess it will have to.

  • 8 Calculus June 11, 2021, 7:15 pm

    More generally PV panels would seem to be a good hedge against rising energy prices. My water ones are going well after 10 years. Nothing beats a solar heated shower!

  • 9 Brodes (not Brod!) June 11, 2021, 8:12 pm

    My view (as a random and unqualified person on the internet) is that the best inflation hedge is to take out a significant fixed rate mortgage, and buy real assets. E.g. invest in a diversified share portfolio. I am invested 1:1 vanguard USA: Vanguard whole world. 5 year fixes at less than 1.5% are available (e.g. nationwide). 10 year fixes at just over 2% available too.
    Of course, you will need a strong stomach when the next crash comes around. Which it will.
    Over the long term, I am hopeful that global equities will return well in excess of 1.5% nominal.

  • 10 Matthew June 11, 2021, 11:09 pm

    Andy Haldane always seems out of step with the rest of the BoE – why? Is it for him a careerist position that makes him different and look like a genius one day to get the top job? I read that labour favour him too.

    Inflation might damage an income flow from an investment but within a company it’s debt will be devaluing – yes rates upon that debt might increase but at least if the company pays that down then it’s money is adding a meaningful return, whereas with low rates there is not so much a company can do to its finances alone to improve its cashflow, only grow or return cash to shareholders.

    On art, like all collectables it’s a bit of greater fool theory which has to end with a collector willing to pay more than the speculators for some reason. At least art doesn’t require the maintenance that classic cars or wine might, but if it was that easy to turn a profit on it every hedge fund and bank would be all over it, and they wouldn’t be advertising it. To me sounds like they are trying to create greater fools for what they already hold.

  • 11 AVB June 12, 2021, 8:24 am

    So long as we get decent wage inflation it will be good for paying off the mortgage (even more so if locked into a low rate).

  • 12 Matthew June 12, 2021, 1:26 pm

    @avr – wage inflation needs to be accompanied by tax threshold increases, otherwise the tax burden upon employment increases. Bear in mind that we are customers as well as earners, and that a wage rise for everyone else who we’re paying will have more tax burden on it and we’ll be paying from income that was more taxed ourselves.

    It might inflate away corporate debt to some extent although when inflation is driven by wages it’s harder on the businesses we all own in our pensions etc, their future growth might be slowed, so they can only naturally create more labour demand to push wages up naturally if they’re not pushed to do it artificially quickly.

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