By the Numbers
Which asset classes effectively hedge inflation?
Mary Beth Fisher, PhD | February 14, 2022
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
The economic theory of asset prices and how asset returns are related to inflation began in earnest in the 1930s. Economists and investors sought to identify assets whose returns would provide protection against inflation. The techniques, data and sophistication of models used to study inflation and asset prices have evolved over time, and much of what was previously thought to be true based on seminal studies in the field is currently contested. Of the four major asset classes examined after Treasury inflation protected securities, research indicates that real estate appears to be the best hedge for inflation, followed by common stocks.
Even recently published studies using more sophisticated methodology on the same asset class can produce conflicting results. Of the four major asset classes evaluated:
- Common stocks and real estate both appear to provide some long term protection against inflation, but common stocks and REITs can be perverse hedges over short periods, meaning their prices / returns may fall initially as inflation rises;
- Nominal sovereign bills and bonds do not hedge against inflation shocks, but longer maturity sovereign bonds offer some limited protection against inflation over very long term horizons (8 to 10 years);
- Studies of gold published since the 2008 financial crisis seem to completely discredit its historically documented link to inflation.
The research supports the following fixed income trade recommendations to hedge against inflation:
- Buy commercial or residential real estate in privately held deals as a short term or long term hedge against inflation;
- Buy real estate via securitized deals as a long term hedge (5 or more years);
- Be outright short bills or short term bonds over the next year or while the Fed is hiking (negative carry);
- Enter into Treasury curve flatteners over short to medium term (negative carry);
- Buy Treasury inflation protected securities (TIPS).
An overview of the scientific literature on inflation hedging for the four major asset classes was published in What do scientists know about inflation hedging? (purchase required) by Stephan Arnold and Benjamin Auer, in the North American Journal of Economics and Finance, September 2015. A brief synopsis of their literature review and conclusions are summarized below.
- Inflation is defined as ‘a process of continuously rising prices, or equivalently, of a continuously falling value of money’.
- The rate of inflation is most often estimated by measuring changes in consumer price indices (CPI). Alternative inflation proxies include changes in producer price indices (PPI), wholesale price indices (WPI), retail price indices (RPI) or GDP deflators.
An asset is considered an inflation hedge if its real return is independent of the rate of inflation. This is the definition used in virtually all empirical studies of inflation hedging.
- Real return = Nominal return – Rate of inflation
- This implies that the nominal return of the asset has to be positively correlated with the rate of inflation.
- A perfect hedge would be an asset with a correlation of 1 between the nominal return and inflation. This is true of assets like Treasury Inflation Protected Securities (TIPS), whose principal is tied to changes in the CPI.
- Assets that are not indexed to inflation can serve as effective hedges or partial hedges to inflation if their returns are still highly correlated to inflation, and that correlation is stable over time.
The goal of inflation hedging is to identify assets whose returns are positively correlated with inflation rates, so that as inflation rises the returns of these assets also rise, and provide investors protection against inflation. Additional considerations include:
- Do the assets hedge both expected and unexpected inflation?
- Do they provide protection in the short run, in the long run, or in both?
- Is the hedging effectiveness stable over time and across various economic states or regimes, or is it particular to a specific time period?
In theory, any asset should act as a hedge against inflation because expected nominal returns should incorporate new information about the level of goods pricing in an efficient market. In practice, researchers’ empirical analysis of asset returns versus inflation has produced decidedly mixed – and at times conflicting – results that vary across asset classes.
- Common stocks – There is no broad consensus, but both early and more recent studies indicate that stocks appear to be poor inflation hedges in the short run, meaning for periods under 1 year, as their returns are negatively related to changes in the rate of inflation. This means stocks are a perverse hedge for inflation and would only be effective if investors short the assets. Over the long term, for periods of at least 5 years, most recent studies find that stocks do serve as an hedge for inflation, though it has been more effective since the early 1980s when the volatility of inflation declined.
- Gold – There are multiple streams of research studying both economic and financial aspects of gold as an asset class. One of those streams includes the capacity for gold to function as a portfolio diversifier, hedge or safe haven from inflation. Unfortunately these studies are dramatically conflicting. Most early studies found that gold and inflation prices were cointegrated, meaning that the relationship between gold prices and inflation was stable over long periods of time. However, a synopsis of studies published since the 2008 crisis concludes that “any link between gold and inflation is either non-existent, merely driven by outliers or strongly time-dependent.”
- Fixed income securities – These studies typically restrict their analysis to the relationship of interest rates and inflation of sovereign bills and bonds of developed countries only, and few directly test the inflation hedging effectiveness of the securities. Nominal bills and bonds tend to show negative correlation with inflation in the short run, so they could be used as perverse hedges against inflation. In the very long run, meaning an investment horizons of 8 to 10 years, there is some limited potential for nominal bonds to serve as an inflation hedge. Drawbacks include that nominal bonds tend to hedge against expected inflation but fail to hedge unexpected inflation, and hedge performance is sensitive to the time period and horizon chosen.
- Real estate – Evidence from earlier studies, prior to 1990, indicate that direct holdings of real estate, both commercial and residential, serve as at least a partial hedge against inflation. Indirect real estate holdings through public REITs, whose total returns are analyzed, showed a negative correlation to inflation in the short run, though that was possibly due to the tendency for REIT prices to follow those of common stocks. The results of more recent studies that use a cointegration technique are mixed, showing that real estate’s ability to serve as an inflation hedge depends on how it’s held (directly as private assets or indirectly through REITs), the choice of sample period and the property type. Privately-owned real estate appears to provide a significant hedge to both expected and unexpected inflation, though there are significant data-related issues that limit the validity of some published results. Regardless of how it is held, the adjustment to changes in inflation is gradual, so real estate does not often offer short term protection against inflation.
The entire paper is well worth reading, and presents a much more nuanced and complex picture of the various studies than is recapped here.
Mary Beth Fisher, PhD
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