Wednesday, December 9, 2009

Hedging Against Inflation

From CXO Advisory Group:

How can long-term investors best hedge against inflation's erosion of purchasing power? In their April 2009 paper entitled "Inflation Hedging for Long-Term Investors", Alexander Attié and Shaun Roache assess the inflation hedging properties of traditional asset classes over different investment horizons. Using total return indexes for several asset classes from initial data availability (January 1927 at the earliest) through November 2008, they conclude that:

  • Over a one-year investment horizon:
    • Cash has not been an effective hedge against inflation.
    • Stock and bond returns tend to decrease as the inflation rate rises, particularly since 1973. A 1% increase in the inflation rate over a one-year period leads to a decline in the nominal annual return on bonds (equities) of about 1-2% (3%).
    • Commodity returns tend to increase as the inflation rate rises. A 1% increase in the inflation rate over a one-year period leads to an increase in the nominal annual returns for the CRB Index, the GSCI and the spot gold price ranging from about 4% to 10%.
  • Over the long run:
    • Cash returns gradually increase with the inflation rate, but the response is less than offsetting.
    • Long-term Treasury bonds are the worst inflation hedge immediately after an inflation rate shock, but after about 3 years return dynamics begin to work in their favor and higher yields offset price declines.
    • Equity returns decline in the months following an inflation shock and do not meaningfully recover, making them the worst inflation hedge over the long run.
    • Commodities are the best performing asset class over the short term, but long-term implications of inflation on the business cycle cause their prices to fall gradually over the long run.
  • The dynamics of deflation shocks may be very different.
  • Investors may be able to enhance inflation protection through tactical asset allocation by tilting toward commodities and away from bonds immediately after positive inflation shocks, but then reversing that tilt when commodity returns begin to diminish. Equity reallocations are less efficient in hedging against higher inflation, and investors should perhaps view equities as very long-term holdings for which inflation cycles average out.

The following table, taken from the paper, summarizes the effects of unexpected increases in the inflation rate on returns for different asset classes based on available index data. Elasticity is the cumulative percent change in the asset class total return divided by the cumulative percent change in inflation. An elasticity of 1 indicates that the asset class provides a perfect hedge against inflation shocks....TABLE

And from Bloomberg:

Gold Isn’t the Best Protection Against Inflation

Economic chaos? The dollar crumbling? Central banks printing money like crazy? Probably the only real surprise about the surge in gold prices over the last few months is that it took so long to arrive.

Last week gold touched an all-time high of $1,227.50. Back in September it was still less than $1,000. Chalk that up as a victory for the gold bugs.

This week, the price is heading down, dropping below $1,200. Chalk that up as a victory for the gold skeptics, who regularly point out that the metal’s value is just a sentimental memory from a long-buried era.

In reality, while investors are right to be nervous about inflation, maybe they are catching on that it’s wrong to see gold as the best hedge against a general rise in prices. There are plenty of alternatives: equities, property, oil, luxuries or private-equity funds should prove just as effective a way of shielding yourself.

It isn’t hard to figure out why investors had been getting interested in gold again. Central banks are pumping freshly minted money into the system. A few hundred years of economic history says that eventually this will lead to inflation. It might be next year, or the year after. It doesn’t make much difference -- it will arrive sooner or later, and you’ll need to get your portfolio in shape before it does.

Alloyed Record

But gold? Whether it’s a hedge against inflation depends on where you want to start drawing the graph. Back in 2002, gold was less than $300. If you bought it then, you’d certainly have protected yourself against rising prices -- and made a fat profit as well. The 1990s were a different story. Gold started that decade at around $400, and ended it below $300. Not so great. As for the 1980s, forget it: gold lost almost half its value during that decade.

In reality, gold has a mixed record. Nor should you be surprised about that. A few industrial uses, and jewelry, aside, gold is valuable only insofar as other investors think it is valuable. By itself it isn’t necessarily worth anything. Nor does it generate interest or dividends. If the price doesn’t rise, you don’t get anything....MORE