Global inflation, the "gray rhinoceros" that had barely been heard for the past 10 years, has quietly arrived.
Last week, the latest U.S. Consumer Price Index (CPI) for February grew 7.9 percent year-on-year, the fastest pace since June 1982. From groceries to cars to rental prices, almost everything in the United States is rising in price. Not only the United States, but also the data released by Eurostat on February 2 local time showed that the euro area CPI rose by 5.8% year-on-year in February, setting a record for the highest increase in history. Uk inflation is also at a 30-year high, and the CPI of some emerging market countries continues to be high despite successive interest rate hikes by central banks.
According to Charles Schwab's Trader Sentiment Survey, nearly nine in ten traders (88 percent) have begun to worry about inflation. So, how do all major asset classes perform in an inflationary environment, and how should investors trade inflation?
Commodities hedged inflation again
Commodities are often the first way investors think of hedging inflation in an inflationary environment.
John Williamson, an analyst at Gild Group, said a study by Mangroup found that commodities performed best overall over the past 8 periods of high inflation, with stocks underperforming and lower bond returns.
Paul Tudor Jones, a well-known hedge fund manager on Wall Street, recently said that for some time now, commodities seem to be seriously undervalued compared to financial assets such as stocks. Even if the Fed later aggressively tightens monetary policy to fight inflation, commodities will still outperform financial assets such as stocks.
Perhaps it is this consensus that superimposes the escalation of the crisis in Ukraine, from precious metals to grain to energy, and commodities have soared across the board. Jeff Currie, a senior commodities analyst at Goldman Sachs, said that of the 28 commodities, 19 are currently in a futures discount, that is, the forward futures price is lower than the near-month futures price. He noted that the situation showed that the current supply shortage in commodity markets was the most severe since 1997.
Karen Karniol-Tambour, an executive at Bridgewater, the world's largest hedge fund, said commodities were the least underutilized hedge against inflation as the economy expanded and prices rose. "What you need to look for is assets that will perform well despite high economic growth and inflationary pressures. I personally prefer metals and carbon rights. He said.
However, while more and more investors and institutions are joining the buying commodity hedge inflation camp, the leveraged investment multiple of institutional investment in commodities has decreased compared with the past two years due to the imminent tightening of monetary policy in Europe and the United States. During the Fed's extremely accommodative monetary policy over the past two years, some hedge funds once used 6 times the leverage to buy commodities, and now this multiple has dropped to about 4.5 times.
Kenneth French, a Chicago-based economist who is one of the proponents of the three-factor model, one of the famous multi-factor pricing models in quantitative investing, has also pointed out that over time, commodities will have the same "Sharpe ratio" as the stock market, so the claim that commodities will be negatively correlated with stock and bond returns and can hedge inflation well will become untenable. In fact, commodity indexes are typically 10 to 15 times more volatile than inflation, making it impossible for investors to accurately estimate the expected returns of commodities. So, in the long run, investors using commodities to hedge inflation will almost certainly increase the risk to their portfolios.
Stock or bond?
In terms of large-scale asset classes, analysts have also found that in a high-inflation environment, investors do not need to struggle with whether to choose stocks or bonds, because their return rates are actually almost the same.
Ray LeVitre, founder of Net Worth Advisory Group and a registered financial planner, studied periods of high inflation for nearly a century and found that both equity and debt rebounded strongly in the years following high inflation. He simulated the return on investment in holding equities in three different ways during the period of sustainedly high inflation in the 1970s (1973-1982). He found that the inflation spiral is devastating for anyone who holds stocks. Specifically, if $10,000 had been fully invested in multiple stocks in 1972 — from large-cap to small-cap stocks, from growth stocks to value stocks — it would have shrunk by $3,935 in two years, with losses of nearly 40 percent. But by 1976, the money would be back to $10,000, and by 1982, that number would more than double to $22,827, equivalent to outperforming inflation by $111; investing $10,000 entirely in bond portfolios would result in a $1,275 behind inflation, but if you only bought short-term bonds such as Treasury bills, you would also be close to beating inflation; and if you invested in stocks and bonds in half, you could outperform inflation by $209.
"Interestingly, each portfolio I tested offered very close rates of return and kept up with inflation with varying degrees of volatility." He concluded.
Roubini, emeritus professor at NYU Stern School of Business and chief economist at Atlas Asset Management, known as the "Doomsday Doctor," recently wrote that traditional 60/40 debt portfolios are not suitable for inflation. The reason for this traditional allocation is that stock and bond prices are often negatively correlated, so this combination can balance the risk and return of the portfolio. But the negative correlation between stock and bond prices is premised on low inflation. When inflation rises, bond returns become negative, while high inflation is bad for stocks because it inspires higher interest rates— both nominal and real. Therefore, as inflation rises, the correlation between stock and bond prices turns from negative to positive, and higher inflation rates can cause both stocks and bonds to be damaged.
To that end, Roubini suggested exchanging 40 percent of bonds for three other options that would better hedge inflation: the first is to invest in inflation-indexed bonds or short-term government bonds, where yields are quickly repriced as inflation rises, and the second option is to invest in gold and other precious metals, which tend to rise when inflation is higher. Gold is even more unique, as well as being a good hedging tool, it can also withstand a variety of political and geopolitical risks that could impact the world in the coming years, and finally, it can also invest in physical assets with a relatively limited supply, such as land, real estate and infrastructure.
How to invest in stocks and bonds?
For the specific investment strategies of the two major categories of stocks and bonds, analysts also gave a number of principled suggestions.
Stocks in "defensive," non-cyclical sectors such as consumer necessities and utilities tend to weather periods of inflation and recession better than other sectors, Williamson said, because public demand for these goods and services typically remains constant. In addition, in times of high inflation, value stocks also typically outperform growth stocks. In fact, investors are already leaning toward small-cap value stocks. This is also the consensus of many market analysts.
JPMorgan Chase did not give a preference for stocks, but made a list of stocks to avoid. Dubravko Lakos-Bujas, head of global equity research at JPMorgan Chase& Co., expects the stocks to outperform the broader market if inflation continues to rise. The list of "underperforming stocks" covers multiple industries including healthcare, consumer discretionary, and technology. Consumer discretionary stocks tend to be more sensitive to rising inflation, he said, because as prices rise, consumers can choose not to buy such products, such as Target (TGT), McDonald's (MCD) and Dollar General (DG). There are also multiple healthcare stocks on the list, including Moderna (MRNA), Eli Lilly (LLY) and Regeneron Pharmaceuticals (REGN). Regeneron's shares are down about 1 percent this year, while Eli Lilly and Moderna are down about 13 percent and 42 percent, respectively. Among the technology stocks, Microsoft (MSFT) and Zoom Video (ZM) are included in this list.
In addition, some analysts have suggested that they choose global stocks other than US stocks. Tom Lydon, CEO of ETFTrends, said: "We are about to witness higher interest rates, especially in the US. But outside the U.S., not all developed countries are about to experience the throes of rising interest rates. People are diversifying, such as in emerging markets. Emerging markets have some special advantages, not only with better opportunities to reap excess returns, but also by avoiding hawkish central banks like the Fed. ”
Among bonds, some analysts are bullish on short-term bonds and inflation-preserved Treasuries (TPIS).
Williamson said short-term bonds are less sensitive to interest rate changes because after maturity, investors can quickly switch to new bonds with higher yields. "During the period of double-digit U.S. inflation in the 1970s, the returns of ultra-short-term Treasury bills (T-bills) with a maturity of 0 to 3 months were essentially in tandem with inflation. From 1928 to 2020, the annualized historical yield of the 3-month Treasury Bill was 3.32%, and the average inflation rate for this period was 3.02%, which means that the real return adjusted for inflation was 0.3%. "We expect that this time, the return on treasury bills will also be slightly higher than the rate of inflation." In addition to specific bonds, Williams added that investors can also hold short-term bond-related ETFs, such as VGSH, an ETF owned by Vanguard that tracks 1- to 3-year short-term Treasury bonds, and investors who focus on investing in short-term Treasury bills can choose iShares' ETF SGOV.
In addition, Williams said, investors can also choose to launch in 1997 as "the only relatively new bond product that is truly related to inflation" - the Treasury Inflation Protection Securities (TIPS). He said that while tipps' resilience to inflation cannot be measured by their performance during historical periods of inflation, TIPS' returns have indeed been overall better than those of nominal bonds over the past two years as inflation has gradually moved higher than historical averages.
Alternative investments
In addition to the most traditional types of investments, some analysts also recommend that investors defeat inflation through inflation-linked derivatives, REITS, digital currencies, etc.
For example, traders can fend off inflation through derivatives called "zero coupon inflation swaps." The trading rule for this product is that the buyer pays a fixed interest rate to the seller. In return, after a fixed period of time, they can get floating rates pegged to the U.S. CPI. Lindsay Politi, a former inflation trader who currently manages more than $2 billion in assets at One River Asset Management, said the price of the zero-interest inflation swap product hit a record high last November and is still trading at more than twice the historical average. Investors who bought a 12-month zero-interest inflation swap a year ago can now earn more than 5 percent.
Other traders hedge inflation with the Sterling Nighter Index Average. A spokesman for intercontinental exchange Inc. said futures and options linked to the pound's overnight average have increased significantly this year. On February 15, the number of related futures and options that had not been performed reached a record 7.9 million, with an estimated notional value of 1.99 trillion pounds (about $2.7 trillion).
In addition, some investors are willing to choose digital currencies as a hedging tool. CME Group Inc.'s January bitcoin futures contracts increased by 20% month-on-month. Tim McCourt, managing director and global head of equity products at CME, said some traders see cryptocurrencies as isolated from monetary policy and a safe haven for inflationary pressures.
In the aforementioned Schwab survey, 26 percent of respondents said they would buy cryptocurrencies or cryptocurrency-related products, 33 percent of traders surveyed said they would buy real estate or real estate investment trusts (REITs) to hedge inflation, 23 percent said they would still choose gold, and 16 percent said they would hold global stocks.
Some ETFs that track a basket of inflation-sensitive assets also offer a more "lazy" way to hedge inflation. John Davi, founder and CEO of Astoria Portfolio Advisors, said another way to diversify against inflation is to invest in inflation hedge funds, such as ASTORIA's ASTORIA Inflation-Sensitive ETF (PPI). The ETF primarily holds positions in banks, energy, industrials, materials, and other sectors that typically perform best during recession cycles. "The CPI in the United States has exceeded 7%, and from a global perspective, the overall inflation rate should also exceed 5%. Looking at energy, food, groceries and house prices alone, real inflation levels are higher. I really recommend that investors allocate more anti-inflation varieties in their portfolios. He said.
Mike Akins, founding partner of ETF Action, noted by observing ETF funding flows: "There is a big shift in capital flows, from technology, communication services to energy and finance. Energy ETFs are now funded in an over-allocated industry. Commodity ETFs in general benefit from spot premiums, or futures contract rollovers are profitable when futures prices for the current month are above the price on the curve. ”
For example, the WisdomTree Continuous Commodity Index Fund ETF (GCC), which has held positions in energy, agriculture, metals futures contracts, and bitcoin futures, is up about 9 percent year-to-date. Jeremy Schwartz, head of global research and executive vice president at WisdomTree Asset Management, said the GCC was the best performer of WidowTree's 75 ETFs in 2022 and is currently being used as an inflation hedge.
The Amplify ETF also previously launched the Amplify Inflation Fighter ETF (IWIN), which tracks inflation-sensitive equities and commodity futures contracts. The ETF's main holdings are mining companies, property developers, land developers, homebuilders and REITs, as well as agricultural products, gold and bitcoin.