How to Invest During Inflation: An Empirical Analysis

Meanwhile, core inflation, which ignores food and energy prices, is up 5.3% from a year ago. The Fed’s hikes, resulting in a cumulative 5 percentage point increase, has brought inflation down but the number is still well above the 2% goal.

Finishing the job may prove difficult. Why? Because other numbers suggest that reaching 2% is going to be increasingly challenging.

For example, increases in workers’ pay are at about 6% since the Fed started raising rates. Economists at Citibank believe this pace is “consistent with underlying price inflation stably around 4.5% to 5%." Additionally, groceries increased 8.2% year-over-year last month. These numbers might explain why BlackRock Inc. Chief Executive Officer Larry Fink believes “we’re going to have stickier inflation for longer.”

Consumer Price Index

change from one year earlier

Source: NBC News

While progress towards 2% inflation has been encouraging, investors still need a plan for a setting in which the current 4% figure remains stubbornly fixed.

Fortunately, work from Duke University professor and NBER research associate Campbell Harvey and others offers some insights on how to build such a plan.

Here we look at their paper, The Best Strategies for Inflationary Times and examine:

1. The research approach to answering that question
2. The results of their investigation
3. The takeaways for investors

The Research

Campbell and the other researchers wanted to understand what inflation means for investors because it is a setting that is unfamiliar to so many. As they explain, “over the past three decades, a sustained surge in inflation has been absent in developed markets.” They cite three reasons why the current setting has been primed for inflation:

• An enormous increase in the M2 money supply
• Massive fiscal accommodation
• An increase in long-term bond yields

Next, the team decided to analyze passive and active strategies across several asset classes over the past 95 years for the US, UK, and Japan.

The question they wanted to answer was: “what passive and dynamic investments have historically tended to do well (or poorly) in environments of high and rising inflation?” The researchers define inflation as a period when year-over-year inflation is accelerating to 5% or more. Based on this definition, there have been eight inflationary regimes in the US. They used this same definition for the portion of their research focusing on the UK and Japan.

Some of the US inflationary periods include major events like the US entering WWII (1941-1942), the end of Bretton Woods (1966-1970), and a portion of Regan’s presidency (1987-1990). Then they examined how different assets like commodities, equities, real estate and fixed income performed during these eight periods.

Similarly, Campbell and the others identified inflationary periods for the UK and Japan based on the Retail Price Index (RPI) for the UK and the Nationwide Consumer Price Index (CPI) for Japan. There were fourteen periods of rising inflation in the UK and twelve in Japan. The assets examined included government bonds, equities, and residential real estate.

Finally, the researchers also studied how long-short stock factor portfolios and trend

strategies applied to futures and forwards performed in inflationary settings.

The Results

The researchers’ exhaustive work yielded a wealth of valuable information for investors. Below are some of the key findings:

The US Market:

• Commodities have historically performed best during high and rising inflation with “a perfect track record of generating positive real returns” during the eight US regimes, averaging an annualized +14% real return. Here, commodities are defined as a month-by-month, equally weighted average of all commodity groups. Within the commodities group energies lead with an annualized +41% real return during inflation regimes.
• US residential real estate (Case-Shiller US house price index) experienced an annualized real return of -2% during inflationary regimes.
• The performance of 10-year Treasury bonds during high and rising inflation periods is weak. In nominal terms, the average annualized return during inflationary regimes is +3% but is -5% in real terms.
• The 60-40 equity-bond portfolio yielded poor performance during inflationary periods, as seen by a -6% real annualized return. Here, stocks are defined as the S&P 500 and bonds are a US 10-year Treasury bond investment.
• Small companies underperform during inflation and “the premium for being long small size and short large size is -4% a year in inflationary periods, compared to +1% in normal times.”
• A momentum strategy performs well during high inflation as seen by an average return of +8% and a 75% hit rate across the eight episodes.
• Each of the five trend strategies examined generated a positive annualized real return during inflationary periods.
• Treasury Inflation-Protected Securities (TIPS) generated a 2% real return during high inflation.

The UK and Japan Markets:

• The worst performing asset class is bonds when their own country experiences inflation.
• Commodities perform well in these markets during high inflation.
• UK equities perform slightly better than US stocks and are flat, in real terms, across the 14 regimes, with a 43% positive hit rate.
• UK residential real estate generated a 1% annualized real return during inflation periods
• Japanese residential real estate generated a 12% annualized real return during inflation periods.

The Takeaway for Investors

The data shows that investors who want to safeguard part of their holdings from inflation should strongly consider commodities. In fact, the authors show that commodities even hold their value during non-inflationary periods as seen by the +1% annualized real return among aggregate commodities seen in chart 1 below. The strongest performers among commodities are energies, industrial metals, and gold.

Meanwhile, bonds are a bad bet during high inflation and have posted negative performance in nearly every scenario as seen in chart 2.

If investors seek an active approach to fighting inflation, rather than a passive one, a momentum strategy wins. Here, the authors define trend as a “time-series momentum (trend) strategy applied to liquid futures and forwards (or proxies) across assets.”

Finally, a passive strategy of investing long in consumer durables generated the worst annualized real return of -15% during high inflation.

Chart 1: Commodities Perform Well During Inflation

Source: SSRN

Chart 2: Performance Across Assets and Countries in Different Periods

Source: SSRN

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