A major topic now on the minds of many investors locally and globally is inflation. This comes as no surprise as we Jamaicans have ourselves already seen some price movements at the pumps as global crude oil prices are currently up 48% year to date. Inflation is simply, the fall in the value of money and a debate into its root cause can swiftly detour into debates revolving around Keynesian economics, demand, and cost push inflation, or if it’s simply a result of too much money in circulation. Without speaking too deeply into its origins at the moment, we believe a more practical exercise would be to stay informed as to what are the best ways to protect your personal investment portfolio from the subtle but erosive effects of inflation by looking at past data driven research done on the topic.
It is generally thought that in times of inflation it is most reasonable to own real physical assets, whose value tend to rise commensurately with inflation as opposed to financial assets. These assets are typically thought to be commodities (particularly investment commodities such as gold and silver) and real estate. The financial literature tends to be more conclusive as it relates to commodities as opposed to real estate. Mahlstedt and Zagst (2016) in their study on inflation protected investment strategies, noted that adding commodities (i.e. via futures) to a portfolio of stocks and bonds drastically improved performance in inflationary periods particularly in the short run. Interestingly, even though gold is the most popular investment commodity, particularly due to its diversification properties, majority of the literature have found that it is typically the non-investment commodities that performed the best in terms of real returns in high inflationary environments. An explanation for this being the fact that these commodities are typically the ones that are driving a lot of past inflationary cycles that we’ve seen directly (think crude oil, rare earth metal and copper prices throughout the years).
REITS and Equities
It is also often thought that REITS and equity would offer some amount of protection against inflation. The logic being close to that of commodities, being that they represent some stake in real assets (for the most part) that would therefore increase in value somewhat in-line with the overall price level. While studies have shown this to be true for the most part, it has been seen that this hedge has primarily been over the long run horizon. Narkowitz(2020) noted that while REITS and Equity do have inflation hedging properties they need longer time horizons for which to pass on higher prices and rents to their consumers. It is however noted that while equities performed poorly in the short term due to unexpected inflation, they tend to keep up with prices in the long run.
Most research have shown conditional results for the ability of bonds to protect against inflation. That is, they are poor in protecting against inflation in the short term (particularly long maturity bonds) while some have noted that they can present good opportunities depending on the time horizon and the source of inflation. That is high unexpected inflation tends to increase bond yields as investors require higher premiums, which means that inversely bond prices are lower for an overall lower short-term real return. In theory this is due to high inflation eroding the fixed income payments received, leading to a lower present value for bonds. However, some studies have shown that in the case of a short-term unexpected inflationary shock, in the long run, long term bonds have shown the ability to generate excess returns. This is because of the higher yields dominating the price declines in producing higher total returns as inflation subsidies.
Practical Portfolio Implications
We wouldn’t expect you to start hoarding bananas in your backyard to hedge against inflation, for there are other ways to incorporate commodities in your portfolio. This can be done by gaining exposure to entities that are heavy in specific commodities sectors (think oil stock and bonds in an oil price boom, or the sovereign debt of these commodity exporting countries) or to even incorporate commodity ETFs and futures into your portfolio. It may also be helpful to include gold exposure for the diversification benefits due to its low correlation with other asset classes. As it relates more generally to equity and REITs in your portfolio this decision might depend on your investment horizon and outlook. As we have noted they both tend to hedge well in the long run and hence it would be recommended that if your investment horizon is sufficiently long and/or if you have the belief that the inflationary period might be extended, to increase your exposure to these asset classes. Lastly it might be prudent to cut your exposure to longer term bonds if you wish to reduce your inflation risk, particularly in the short run.
Written by Peter-George Simon, Senior Investment Strategy Analyst
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