Financial markets expect a certain level of inflation and associate it with the value of their established assets, a condition that is theoretically neutral for investment portfolios. Unexpected inflation on the other hand can reduce the purchasing power of the portfolio, especially a challenge for investors in small areas of investment such as retirees.
Do some asset classes weather unpredictable inflation, as we have seen recently, better than others? Recent vanguard research suggests that products differ as a vehicle for hedging against unpredictable inflation.
Over the past three decades, the product has received a statistically significant and widely consistent positive inflation beta, or predictive response to the unit of inflation. PhD research led by Su Wang, assistant portfolio manager at Vanguard Quantitative Equity Group, found that product inflation has fluctuated widely between beta 7 and 9 over the past decade. Unexpected inflation will increase from 7% to 9% on products.D
Product inflation-hedging power is strong and consistent
Do other asset classes hedge against inflation? Nominal bonds are certainly not as simple facts of mathematics. “You may not be able to predict the direction of the interest rate, but whenever the interest rate goes down, you know exactly what is happening with your bonds,” Mrs. Wang explained. “There is not much uncertainty. Rising inflation leads to higher rates and bond prices fall.
Inflation-protected bonds are inherently intended to hedge against inflation. But much lower beta (about 1) than unpredictable inflation, they will need to allocate significantly higher portfolios to achieve the same hedging effect as the products.2
Discussing equity as an inflation hedge is more complicated. Our study reveals a sharp contrast between the hedging power of equities compared to products. “Equities have a love-hate relationship with unpredictable inflation,” Ms. Wang said. The contrast presents itself as an inconsistency manifested in three distinct stages over the past three decades.
The broad stock index is not a consistent hedge against unexpected inflation
Wang said the 1990s marked the “hate” stage of the love-hate relationship. More than a decade after the then-chairman, Paul Volker, doubled interest rates to tackle the Federal Reserve’s inflation, the Russell 3000 index, which represents about 98% of the U.S. equity market, had a negative inflation beta of about 2 to 9. A 1% increase in unexpected inflation would be equivalent to a 2% to 9% decrease in the index.
After the dot-com bubble burst, the index’s unexpected inflation beta increased and became positive in the 2000s. In the low-growth, low-inflation era of 2010, markets decided that little inflation would not be a bad thing, and unexpected inflation beta became positive and stayed there. “Any sign of inflation after the global financial crisis was a positive signal for equity,” Ms. Wang said. Beta has remained positive but has weakened in recent years, which means less of a market for what inflation might mean for returns in the coming years.
The Vanguard study further found that the hedging power of U.S. equities is likely to decline in the future, as product-related sectors, including energy and materials, are much smaller than the equity market, and sector-effective inflation hedges are more relative than three decades ago.
Consider unpredictable inflation and portfolio
The asset allocation team within the Vanguard Investment Strategy Group is considering unpredictable inflation – and many other drivers of portfolio returns – as it maximizes the power of the Vanguard Asset Allocation Model (VAAM).
Additional Vanguard research has introduced a new method for creating high-income portfolios that allows for yield targeting. Todd Slanger, a senior investment strategist and lead author of the upcoming study, said the team could focus on targeting the unexpected inflation beta.
VAAM takes input from Vanguard’s proprietary forecasting tool, Vanguard Capital Markets Model®, to optimize portfolios based on investors’ risk preferences. “Typically, model portfolios are created in an ad hoc, subcontracted manner,” Mr. Schlenger said. Unfortunately, he said, such an approach could ignore the best methods of portfolio building used in model-based solutions, such as VAAM, which is more systematic.
A method that targets unexpected inflation can take several thousand potential portfolios and rank them by their inflation beta, filtering portfolios that do not meet the criteria. This will allow VAAM to determine the best allocation of asset class, such as portfolio unpredictable inflation beta-related products, for example, when considering the total revenue and diversity of portfolios, he said.
Ms. Wang stressed that the portfolio is about consideration Unexpected Inflation, not for the fact that the market is already responsible for the value of the asset, and the idea to hedge against inflation, is not to lose it. He said an investor whose goal is to beat inflation would not be concerned about the potential medium-term loss of purchasing power. Instead, they need to have a very long investment horizon.
DThe Vanguard study is based on the Bloomberg Commodity Index, which reflects future price changes in energy, grain, precious metals, industrial metals, livestock and commodities, including soft, coffee, cocoa and sugar.
2The total returns of the Bloomberg Commodity Index consist of commodity returns and returns on securities used in futures contract purchases. The Vanguard study found that using Treasury inflation-protected securities (as opposed to three-month Treasury bills) as collateral increased the unexpected inflation beta of the Bloomberg Commodity Index.
“The power of commodities as an inflation hedge”,