How to defend against inflation?


This is a guest post by Ben Funnell, Man Group’s portfolio manager, and Campbell R. Harvey, a professor at Duke University and Man Group’s investment strategy consultant. Based on their recent research, “The best strategy in times of inflation“, the book is co-authored with Teun Draaisma, Henry Neville and Otto Van Hemert of the Man Group.

Do you remember the last time the inflation rate in the United States exceeded 5%? The unbelievable answer is 1990-much earlier than the time when most investors in operation today were involved. However, with the CPI reaching 4.2% in April, the long-term stocks and bonds held by most large asset owners (these asset classes have historically been affected by inflation), now is a good time to start evaluating other inflation hedging strategies.

In newly published research papers In SSRN, The author tries to provide some insights into the best strategy.

It should be emphasized that our research is not intended to predict the level of inflation, but to learn from 34 inflation events in the United States, the United Kingdom, and Japan (using nearly a century of data) to understand the impact of inflation on asset prices.

In order to understand the risks, the article also analyzed eight spikes in the US price level in the past 95 years, in which the inflation rate started from a moderate level and soared to more than 5%. We believe this situation will be very high in the next few quarters. Easy to solve. Then, we will focus on the impact of inflation on various passive and active strategies, as well as strategies to mitigate risks and potentially exacerbate suffering.

A key finding is that it pays to act early rather than act later. If history repeats itself, the traditional 60-40 stock bond portfolio without an inflation hedge may suffer losses. Past experience is derived from the U.S. stock yields obtained from Professor Schiller’s CAPE 1926-2020 database. It also shows that stocks are likely to be hit hard during the inflation surge, and the actual value calculated at an annual rate has dropped on average. 7% (adjusted for inflation). But fixed income will not help, because historically, rising interest rates have caused bond prices to fall. Therefore, the unprotected 60-40 portfolio is a link to risk.

So, how did it feel to invest in previous periods of high inflation? As a clue, we reviewed Warren Buffett’s famous shareholder letters in the late 1970s and early 1980s, when the inflation rate in the United States reached a peak of nearly 15% and mortgage interest rates reached more than 20%. It can be seen from this passage in 1980 that Buffett did not take any measures. letter:

An inflation rate that is not far from the recent inflation rate can make the positive income level of most companies become negative income for all owners. Calculated at the current inflation rate, we believe that individual owners should not expect ordinary American companies to achieve real long-term returns.

In 1977 Fortune magazine article, Buffett expressed his thoughts in more distinct words:

Inflation taxes have a powerful ability to simply consume capital. . . If you think you can jump back and forth into securities by overcoming the inflation tax, then I want to be your broker-but not your partner.

But let us apply this logic to today. By 2020, the US deficit will account for 15% of GDP. The U.S. Congressional Budget Office also predicts that by 2021, the deficit will reach trillions of dollars. This will be the second consecutive double-digit deficit year since World War II. The quantitative easing policy promoted by the Republican Party has also almost doubled the size of the Fed’s balance sheet. This time, currency reserves are growing-since the beginning of a serious policy response in February last year, the annual growth rate of M2 in the United States has been 26%. Even for a cool-headed person, all this is at risk of screaming.

So if stocks and bonds fail the inflation test, where should investors flee? It may sound cliche, but our research shows that commodities have proven to be reliable historical hedging products, because commodity prices first played a role in driving inflation. During the period of inflation, the average rate of return for the energy complex was 41%, while the rate of return for industrial commodities was 19%-both in real terms. The rate of return on gold and silver is also very low.

The Treasury Inflation Protection Securities (TIP) is also designed to hedge against inflation risks. However, this kind of hedging has a cost. Given that the initial rate of return is negative, the current price of the hedge is high: unlike other assets, investors will have to bear negative real returns during non-inflationary periods.

Active strategy is another option. For example, time series momentum is a strategy aimed at profiting in a sustained low-end market or high-end market, achieving an annualized actual rate of return of 25% in the past eight inflation events.

But there is a problem. Although commodity trends follow strategy, and TIPs provide an impressive record of inflation, they provide limited participation capabilities. Therefore, a high-volume active equity strategy must also be considered.

In this case, the two best-performing stocks are energy-complex-related stocks, and the actual return on these stocks is often 1%. The health sector followed closely with a performance of -1%. However, the rate of return on durable consumer goods tends to decline, reaching -15%.

Generally speaking, an active strategy focused on “quality” can bring a 3% return, while “value” can bring a -1% return (after deducting transaction costs). Although this may seem trivial, this rate of return is much higher than the 7% of general equity. In addition, these strategies are highly scalable, which is an important consideration for many large companies in the market.

Become collectible and alternative

However, our research is not limited to traditional financial assets. Researchers have found that in the strategy of the inflation mechanism, alternatives such as real estate and three types of collectibles (especially art, stamps and wine) should also be considered. Although it is more difficult for ordinary retail and institutional investors to obtain collectibles, wine has provided considerable returns during periods of inflation, and wine has risen by as much as 7% during periods of inflation.

The chart below shows the average real annualized total return* of the asset class during the eight periods of U.S. inflation studied:

But what about new asset classes such as cryptocurrencies? In theory, cryptocurrency is not directly related to the monetary policy of any central bank. For example, Bitcoin’s money supply is based on algorithms, and the last part of Bitcoin will be produced in 2140.

So, will cryptocurrencies provide hedging? Based on experience, we obviously have no data. Cryptocurrencies have not yet experienced a significant period of inflation. Quality data has been available since 2013 alone, which is a long time after the last surge in inflation affected Western markets. Second, many cryptocurrencies seem to behave like risky assets. For example, in the first quarter of 2020, the stock market fell by 34%, while Bitcoin plunged by 51%. As investors began to return to risky assets, the stock market rose sharply, and so did Bitcoin.

This analysis shows that cryptocurrencies like Bitcoin are not necessarily independent of the stock market. Therefore, the limited history shows that cryptocurrencies are at best an unreliable inflation hedge.

Nevertheless, in general, this research is reassuring. Studies have found that if a person’s position is correct, the increase in inflation does not necessarily have a catastrophic impact on his investment portfolio. Of course, taking turns in defensive strategies may have an impact in itself. For now, it is the world’s top 20 asset owners with total assets of approximately US$1.1 trillion. The current total distribution of stocks is 49% and the total distribution of bonds is 34%. The weighted sum of their products is less than 1%.

This means that if you are a 60-40 year old investor and do not have the ability to resist inflation, then if your pace is not fast enough, you may be in trouble.

*Commodity price performance comes from front-end futures contracts obtained from the Man AHL database, while trend following performance is constructed based on internal time series momentum strategies applicable to asset liquid futures and forward (or proxy). For wine, we use the index constructed in the 2013 paper by Domson, Rousseau and Spaeniers. For TIP, we use reverse broadcast built by Goldman Sachs. The stock comes from Professor Schiller, and the national debt comes from the global financial database. The product portfolio of all departments and styles comes from the Kenneth R. French database. All data are from 1926 to the present. U.S. residential real estate data is taken from the Case-Shiller U.S. House Price Index.



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