Which assets do best when inflation is rising?

For most investors’ adult lifetimes, inflation has been behaving itself (we’re talking about inflation in the shops and in wages, not in asset prices). That looks like it might finally be about to change.

Markets are waking up to the idea that the post-pandemic bounce might be stronger than expected. That in turn could mean higher inflation – and pressure on interest rates to rise. That’s a big change. So how do you prepare for it?

Which assets can help your portfolio to beat inflation?

If we’re facing inflation, what does that mean for your portfolio? Handily enough, fund management group Schroders has just put out a research paper on the topic, authored by strategist Sean Markowicz. He looked at the performance of seven specific asset classes since March 1973. The paper focuses on US inflation, although I think it’s fair to say that you can assume that the findings are broadly applicable to most developed markets.

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The asset classes examined are bonds (US Treasuries); equities (US stocks); cash (three-month T-bills); property (real estate investment trusts, or Reits); inflation-linked bonds (TIPS); gold; and commodities. Markowicz measures how the assets tend to react to rising inflation (the asset’s “inflation beta”) over the course of a given year. So what did he find?

As you might expect, traditional bonds are hit hardest by inflation. A standard bond pays a fixed income. As inflation rises, the value of that fixed income falls, and so the price of the bond falls (and therefore the yield rises). No real surprise there. And the longer the bond has to go to maturity (and thus the longer the duration – the payback period), the more sensitive it is to an increase in inflation.

Interestingly, the next-worst inflation hedge is equities. You could spend a lot of time talking about “pricing power” and how many companies should be able to pass costs onto consumers. But there’s a bigger issue: rising inflation means that investors become less willing to pay up for future earnings. So the price/earnings multiple falls. So even if profits go up – even if they rise faster than inflation – the effect is not enough (overall) to offset the fact that investors discount the value of these earnings more heavily as inflation rises. Again, it’s all about the time value of money.

The main difference between equities and bonds is that this effect doesn’t kick in for equities until inflation reaches a certain level; you’re usually fine until inflation hits about 3% and then you have to start worrying about it.

Property (as measured by Reits) doesn’t do half as well as most people would perhaps expect. Indeed, Markowicz finds that on average, “Reits have no significant relationship with annual changes in the inflation rate.”

On the one hand, property is a “real’ asset and rents should rise roughly in line with inflation. But on the other hand, property is bought with borrowed money, so rising interest rates drive down prices (if you can’t borrow as much as you used to, then you can’t pay as much for the property). So while property has a tendency to have offered solid real returns regardless of the backdrop (over the period analysed at least), its specific value as an inflation hedge is not clear.

Cash (as measured by T-bills, which move in line with very short-term interest rates) does a good bit better than either bonds or equities. That’s because interest rates have in the past, tended to move up alongside inflation. So cash isn’t necessarily a dead loss during inflationary periods.

There is a caveat however. As Markowicz points out, “situations may arise whereby interest rates are held low to stimulate growth”. This is financial repression and it’s exactly what we suspect will happen in this phase. So while it’s always good to have some cash in your portfolio, keep it there for its optionality value (ie, the flexibility it gives you) rather than because you bet it will keep up with inflation.

Index-linked bonds are the next-best performers. They are clearly decent at hedging inflation. You have to be able to put up with volatility in the short-term though.

Finally, we come to the best hedges by far – gold and commodities. Of the two, gold is the least volatile option (though that’s not saying a great deal).

Why gold is a decent diversifier

Now, clearly the paper only goes back to 1973. That’s a decent time on the human scale, but a pretty short one in terms of economic cycles. The 1970s marked the end of our last big inflationary cycle, with the disinflationary phase kicking off from the early 1980s. So we’re really only looking through one-and-a-bit cycles here.

We also don’t really get any financial repression in this period, which I think makes the figures around both cash and Reits in particular less relevant (if interest rates are held down while inflation rises, you’d expect that to be worse for cash but potentially quite good for property).

That said, the timing is significant, because it marks the end of the Bretton Woods era. Also, it’s hard to measure gold properly before this point because it was pegged to a specific US dollar value ($35 an ounce). And in any case, the outcomes are not widely different to what you’d expect on an intuitive basis.

So what should you do about it? Diversification is important because no one has a crystal ball. So you should never bet on one specific outcome. But if you own a traditional “60/40” portfolio, largely split between bonds and equities, you might want to think about adding some exposure to gold, at least, which Markowicz points out, is a decent portfolio hedge when added to a 60/40 portfolio.

Index-linked bonds are also decent, while cash and property also have benefits in certain circumstances. Commodities work too, but the problem is they go against you badly in non-inflationary times. We’ve written more about why we think it’s worth investing in commodities here, but it’s useful to be aware that they aren’t really a "buy and hold" investment – it’s a cyclical play.

We’re going to have a great deal more about all of this in MoneyWeek magazine over the next few months (and years, maybe). Get your first six issues free here if you don’t already subscribe.