How to Protect Your Portfolio Against Inflation
September 30, 2009
By: Taylor Graff, Senior Associate

In early 2008, oil prices skyrocketed to $140 a barrel, food prices were at all-time highs, the dollar was as weak as it had been in decades and inflation became a significant concern throughout financial markets. But as the credit crisis accelerated, commodity prices collapsed, the velocity of money plummeted and deflation replaced inflation as the primary danger. However, has the danger of inflation disappeared or just paused? The United States has not experienced a significant, prolonged increase in inflation since the 1970’s. The inflation crisis caused pain throughout financial markets as both stocks and bonds floundered with negative real returns. Federal Reserve Chairman Paul Volker’s aggressive interest rate policy finally brought inflation under control in the early 1980’s. Conversely, today monetary and fiscal policy is highly accommodative in response to the credit crisis. Will the extensive government stimulus turn into inflation once economic activity picks up? Only time will tell but the inflation outlook is far less certain than any time in recent memory. If inflation does make a comeback, how can you ensure that your portfolio is safe? Table 1 displays how various asset classes performed during the five largest inflation spikes in the last 40 years. Returns lower than inflation during the period are highlighted in red.

Table 1: Annualized Returns during Inflationary Periods

*Inflation measured by year over year change in CPI as reported by the Bureau of Labor Statistics
**See disclosures at the end of the document for details on calculation of asset class returns
***TIPS began being issued in 1997; during the two inflationary periods since then inflation averaged 4.35%

During these five inflationary periods, commodities and gold were by far the best performers and TIPS also outperformed inflation.

Commodities and gold directly benefit from inflation because their fundamental value is unchanged by inflation while the dollars in which they are priced have declined in value.  TIPS also benefit directly from inflation because the coupon and maturity payments made to the investor are adjusted for realized inflation. 

The effect of inflation on equity-based investments (U.S. and international stocks along with REITs) is somewhat ambiguous.  International stocks (EAFE) gain a marginal, indirect benefit when U.S. inflation is high relative to other nations.  In such a scenario the dollar will depreciate and international assets (not denominated in U.S. dollars) will appreciate.  Table 1 shows EAFE outperformed U.S. stocks in every inflationary period. 

However, all equities are hurt by inflation when it is unexpected.  Greater price volatility diminishes the reliability of future forecasts and companies who lack sufficient pricing power will see profit margins shrink as the cost of raw materials rises.  This is exactly what occurred in 1973 when OPEC’s oil embargo caused the average price per barrelⁱⁱ of oil to go from $2.48 in 1972 to $11.58 in 1974.  Both the tremendous effectiveness of the embargo and the resulting inflationary shockwave were largely unexpected.  Retailers could not raise prices fast enough to keep up with the rapidly rising cost of materials causing profit margins, earnings and consequently stock prices to tumble.  This is shown in chart 1 as producer price inflation significantly outpaced consumer price inflation.

*All figures are annualized

Conversely, in 1979, oil prices spiked again after the Iranian revolution caused oil production in Iran to collapse.   But this time, the global economy was more prepared.  Producers were able to compensate and pass along inflation to consumers.  Stocks underperformed inflation but remained solidly positive. Bonds are directly hurt by inflation because the value of all fixed-dollar future payments has been eroded.  Persistent inflation is especially damaging for bond prices.  In Table 1, the three most recent inflationary periods (1986-1990, 2002-2005 and 2006-2008) were correctly viewed as transitory by the market.  In all three cases, annual inflation declined to under 3% within twelve months of the inflation peak.  Therefore, the bond market was largely unaffected and returns were near or above inflation.

In the 1970’s, inflation was persistent, averaging 7.4% which is the highest level for any decade on record.  This persistent inflation caused bonds to significantly underperform inflation during the two inflationary periods from 1972 to 1980.

This asset class review shows that in the context of an overall investment strategy, TIPS, commodities and gold can all be used to hedge the negative effects of inflation on equity and bond investments.  This conclusion is supported by the historic correlations shown in Table 2.

Table 2:  Historical Correlation between Inflation and Various Asset Classes (1972-2009).

i See disclosures at the end of the document for details on calculation of asset class returns

Commodities have the highest correlation to both inflation and changes in inflation indicating that they provide the most consistent protection against inflation.  Additionally, Table 2 reinforces that TIPS and Gold also perform well in inflationary periods.  Equities and bonds both display a negative correlation to inflation but bonds have a more consistent negative relationship since they are directly harmed by inflation.

So what does this mean for my portfolio?

Using historic data, economic theory and linear regression procedures, CCM calculated the expected marginal effect of inflation upon on a variety of investments which is detailed in Chart 2.  The analysis also took into account the current economic environment in projecting 12 month asset class returns given different rates of inflation over that period.

iii See disclosure at the end of this document for details about the calculations within this graph

This graph should not be construed as a forecast of asset class returns because there are many other factors which affect each asset class return.  Instead, the graph reflects a marginal return against what the return would otherwise be if inflation over the next 12 months remained at 0%.

Possibly the most unexpected implication of chart 2 is that rising inflation (at least up to 5%) will help equity investments (REITs, EAFE and Stocks).  This reflects the current economic situation where inflation is well below its historic average and the equity markets are more concerned about deflation than inflation in the short term.  Near-term inflationary pressures are likely to stem from increased economic activity which will help equity returns.

Chart 2 shows that commodities are the best performer if inflation rises.  Gold also performs well but underperforms the broad commodity market.  Therefore, considering that gold is equally as volatile as commodities, gold is an ineffective hedge.  TIPS perform modestly though they significantly outperform the overall bond market.

The bottom line is that in order to protect your portfolio against inflation, you need the correct inflation hedge which suits the risk profile of your portfolio.  Commodities perform extremely well during inflationary periods but they are a volatile asset class.

Commodities will work well to hedge any portfolio with an allocation to equities built for longer-term performance.  In fact, with the right allocation, commodities can significantly decrease the overall risk and volatility of an equity portfolio in the long-run.

However, in a more conservative portfolio, sensitive to short-term declines, any commodity allocation would need to be modest.  In many cases, especially for pure fixed-income investors, TIPS may provide a better option.  Although TIPS do not perform as well during inflationary periods, TIPS have displayed 80% less volatility^iv than commodities over the last ten years.  To further reduce risk, the duration of a TIPS allocation can be customized to suit the risk/return profile of highly conservative investors.

Therefore, for an investor seeking inflation-protection, commodities and TIPS provide the best options depending on tolerance for volatility.  Commodities generally provide the better hedge and fit well into a long-term strategy accompanied by equities and bonds.  But commodities are not suited for all investors and if your portfolio or your stomach cannot stand the volatility then TIPS are a solid alternative.

How to Invest in Commodities or TIPS?

Investing in TIPS is fairly straightforward.  There are many quality TIPS-specific funds or TIPS can be purchased directly into an investment account.  CCM buys TIPS directly for its clients when the investment is appropriate and valuations are attractive.

Conversely, investing in commodities can be far trickier as there are many pitfalls which can thwart investment objectives.  The most common are:

1. Commodity Exchange Traded Notes (ETNs) – These notes are obligations of a financial institution to pay out the return of a basket of commodities or commodity index.  The problem is that these notes are subject to the credit risk of the financial institution.  If the financial institution runs into fiscal difficulty, the ETN could lose substantial value.
2. Commodity Equity Funds – These funds invest in commodity related stocks rather than actual commodities.  The problem is that the prices of commodity stocks have historically followed the stock market more than the commodity market.
3. Lack of Diversification – Some funds invest heavily in a few (or even one) commodity contract.  This can leave the fund susceptible to regulatory risk, higher volatility and difficulty in rolling over contracts (selling a contract near expiration to buy a longer-dated contract) which can cause tax inefficiency and tracking error.

If you are concerned about inflation and are interested in altering your portfolio to reduce inflation risk, CCM can help you pick the right investments for your investment objectives and risk tolerance to protect principal against the dangers of inflation.  Remember, regardless of your inflation outlook, it is important to have your portfolio best prepared for all risks so that your portfolio’s overall risk is minimized.

i. Indices used for asset class returns throughout paper:

• U.S. Stocks – Dow Jones Total Stock Market Total Return
• EAFE – MSCI EAFE Total Return Net
• REITs:
• 12/31/77-Present:   Dow Jones U.S. Select REIT Total Return
• 12/31/71-12/31/77:  FTSE NAREIT Equity REIT Index Total Return
• Commodities – S&P GSCI Total Return
• Gold – Gold Spot Price
• Bonds:
• 12/31/75-Present:  Barclays Capital Aggregate
• 12/31/72-12/31/75:  Merrill Lynch Government & Corporate Master
• Prior to 12/31/72:  Average return of 5 year and 10 year treasury bonds (CCM Estimate based on Bloomberg data)
• TIPS – Barclays Capital U.S. Inflation Linked Bonds All Maturities Total Return

ii. Source:  Energy Information Agency
iii. Marginal returns in Chart 2 generated by linear least-squares regression procedure using historic inflation/deflation data to explain asset class returns
iv. “Volatility” refers to the standard deviation of the quarterly returns—exact figures below:

• Commodities:  14.1%
• TIPS:  2.7%

v Past results do not guarantee future returns
vi Before making any asset allocation decisions, consider your investment goals and horizon as well as risks and costs associated.  Consult your financial professional.