Inflation Hedges. If you do a quick online search for inflation hedges, you find a lot of conflicting information. My take is the following. Positive correlation: stocks, TIPS, short term cash investments. No long-term positive correlation: commodities, real estate, other bonds. Your thoughts are appreciated as usual.
My Reply
As a rule of thumb I try to ignore past correlations between various asset classes. You already came across the reason why: the signal-to-noise ratio is simply too low. Depending on the market and time period examined (and maybe on who does the examining too), correlations between the same two asset classes can vary widely.
Some correlations are highly logical and should not be ignored. One obvious example relevant to your question is that existing long-term nominal bonds will do poorly in unexpected high inflation. This is more of a tautology than a correlation. Because of that, one of the best -- if not the best -- hedge against high inflation is to hold a big 30-year mortgage at a low fixed rate. Another obvious situation is the reverse: existing long-term nominal bonds do well in an unexpected deflation (assuming the creditworthiness of the issuer is not in question). And perhaps the most obvious of all is that I-Bonds will track inflation perfectly -- with the bonus of not decreasing in value during deflation and with the caveat that inflation will be measured by the Bureau of Labor Statistics, which may not agree with your personal measurement of inflation.
But once we move beyond such obvious scenarios, things get murky very quickly. You'd think that TIPS are a good hedge against inflation. But what if inflation is accompanied by increasing real interest rates, in addition to increasing nominal interest rates? In that case, long-term TIPS might actually start losing value (at least real value). And TIPS simply do not have enough of a history in the US for us to know how their price would move in high inflation. Long TIPS had some strange movements during the depths of deflationary 2008 crisis, when 30-years temporarily had real yield of over 3% while 30-year nominals were at about 2.5%. Taken at face value that would imply inflation expectation of -0.5% for 30 years, which I don't believe was actually the case. One explanation I heard was the TIPS were being liquidated in a panic by hedge funds. I suppose that's as plausible as anything else. Bottom line is we just haven't had TIPS long enough to form meaningful theories of how they would move in extreme events.
Short-term interest rates have tended to track inflation historically, but such rates are also most easily influenced by the actions of the central bank. If, for whatever reason, the central bank decides that higher inflation is desirable, it could prevent short-term -- or for that matter even long-term -- rates from keeping up.
You might think that such powers of the central bank is just another reason to hold the supposed greatest inflation hedge of all, gold. But gold's brief history of being decoupled from the dollar is very mixed. It did have a huge bull market in the 1970s that coincided with very high inflation, but then had miserable 15-20 years in 1980s-1990s while inflation was still significant, and then enjoyed another bull market this century while inflation has been at its lowest in a long time and is expected to stay low for the foreseeable future.
Real estate, farmland, commodities and other "hard assets" are also supposed to provide hedges from inflation. But again, like gold, they seem to be much more influenced by their own speculative or business-cycle related bull and bear markets as opposed to by inflation.
I think it's a healthy investing philosophy to accept and embrace the wide range of possible futures instead of trying to narrow them down using tenuous historical data such as correlations. Future inflation and future interest rates in general can play out too many different ways. About the only thing we can say is that inflation is likely to be in 0% to 4% range most of the time, but will also spend some time outside that range. Not a particularly useful statement, I know, but that's just being realistic about how much we know and how well we can predict the future. Everybody's personal inflation, as opposed to the CPI-U published by the BLS and generally used as synonym for inflation, may well vary even less predictable.
Another thing we can say is that over very long periods of time stocks will keep up with inflation. Inflation is a measure of prices of goods and services that are provided by various companies. As inflation rises, so do the revenues and profits of these companies, and so do their stock prices. That, of course, does not mean that in shorter periods stocks will grow with inflation. Unexpected inflation -- or deflation -- is very damaging to a business. Just think about how difficult it becomes to plan ahead when you don't know even approximately how much your labor and supplies will cost and for how much your goods and services might sell. It may take many years for businesses to adjust to operating in an inflationary environment.
Bottom line is that I would not spend much thinking about inflation other than
- to know that stocks will eventually keep with it
- to know that a low fixed rate mortgage, if you happened to have one, is a very good hedge for it
- to not invest in bonds whose duration is longer than your investing horizon (note that your investing horizon may be longer than your lifetime if you plan to leave something to your children or charity)
Remember that the majority of information prompting you to prepare for and to hedge against inflation originates with the financial industry. Its goal is not to protect your against inflation but to get your wheels spinning looking for and trading various investments and hiring fund managers and financial advisors. Why should you hedge against inflation and not against deflation? Or against the industry you work for becoming obsolete? Or against your job being outsourced overseas? All sorts of terrible financial calamities can happen. Rather than trying to predict one specific set of future events and focusing your efforts on them it is more productive to focus on actions that will benefit you no matter how the unknowable future unfolds: building your career and/or business, living within your means, saving and investing, minimizing investing expenses and taxes, diversifying your portfolio across stocks and bonds.
I will add one last note about one of those generally beneficial actions: minimizing taxes on your investments. Taxes become much more harmful to your financial well-being in high inflation. Let's say you invest exclusively in bonds in taxable accounts (this is not realistic, of course, but works well to make the point) and they happen to deliver historically average -- and as of today completely unattainable -- 3% real return on top of inflation. And let's say your marginal tax rate is 40%, state and federal combined. Let's say inflation is at 2% and your bonds deliver 5% nominal return before taxes (5% - 2% = 3% real return). After taxes you still have 3% return from your bonds, enough for 1% real post-tax return. Compare that to a situation where inflation is at 5% and your bonds deliver 8% nominal, pre-tax returns. That's still the same 3% real return before taxes. But after taxes your bonds will only have about 4.8% of their return left. Now you are actually looking at a negative real return after tax instead of a positive 1%! This is just another reason why you should strive to minimize taxes on your investments. In a very real (get it?) sense, minimizing taxes is a hedge against inflation.
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