Following the economic disruption of the COVID-19 pandemic and the unprecedented stimulus response, supply bottlenecks and a rebound in demand have been a feature of 2021. The inflation runup in the last few U.S. Consumer price Index (CPI) reports is now beginning to look significant relative to history (figure 1).
The coincident lack of clarity in the recent Fed forward guidance may be a good opportunity for investors to re-examine their allocation options and identify investments that provide robust inflation protection, yet still be a good fit from a risk / return perspective.
Figure 1: An Inflation Surprise in 2021
U.S. CPI, year-on-year change
The Inflation Protection Toolbox
In this article, we compare several categories of investments that have traditionally been regarded as having inflation-protection characteristics: commodity futures, standalone gold and Real Estate Investment Trusts (REITs), as well as equities from specific sectors, such as Base Metal and Gold Mining, Energy and Agriculture. Note that given the current low level of real interest rates, we have excluded Treasury Inflation Protected Securities (TIPS) here.¹
The inflationary periods of the 1970s have been studied extensively, although refined equity sector returns data dating back that far is hard to come by. We therefore consider monthly returns and year-on-year changes in U.S. CPI in the 26-year period since 1995, when a large number of the relevant S&P Global Industry Classification Standard (GICS) sub-indices became available.
Focus on Upticks in Inflation
Figure 2 shows the performance statistics for each asset class, as well as for a combined portfolio, over the period. Given that positive inflation is the scenario in which the typical investor seeks some mitigation via positive real returns, we show correlations with changes in inflation conditional on that change being positive (rather than calculating correlations over the entire period). To assess the robustness of these correlations over time, we also examined them on a five-year rolling basis and calculated the percentage of time the rolling correlations were negative, as shown in the last line of the table.
Figure 2. Comparing Different Asset Classes Against Inflation—Hypothetical Backtest
Summary Statistics, January 1995 to June 2021
Source: Bloomberg, Neuberger Berman. Indices used are the Bloomberg Commodity Total Return Index (BCOMTR Index); Gold spot price (XAU Currency); S&P 1500 Composite Gold Sub Industry GICS Index (S15GOLD Index); S&P United States REIT Index (SPREIUSRT Index); S&P 1500 Composite Agricultural Products Sub Industry GICS Index and S&P 1500 Composite Fertilizers and Agricultural Chem Sub Industry GICS Index (S15AGRI Index and S15FERT Index); S&P 1500 Composite Energy Sector GICS Index (SP1500-10); and the S&P 1500 Composite Metals and Mining Industry GICS Index (SP1500-151040). The Model Portfolio is equally weighted by notional exposure across the six asset classes, with Gold and Gold Mining Equities grouped together into a single category, rebalanced monthly.
Interestingly, we find that the equities from the selected sectors have had comparable, if not higher correlation to inflation increases than the index of commodity futures. There could be many reasons for this, including leverage, the absence of the roll costs of futures markets in contango, and in some cases, perhaps, being a step closer to the CPI consumer basket than the raw materials themselves.
Take the Portfolio Approach
Most importantly, however, we observe that a diversified portfolio approach has had the highest correlation to upside inflation and the least frequent incidents of correlation breakdown. This is not surprising because none of the other options has consistently dominated the rest, and the averaging effect of the portfolio therefore provided more stable positive correlation. For instance, in 2015 – 19 the best hedge would have been gold, while the full commodities index was at the bottom of the pack. On the other hand, during periods such as 2000 – 01, or over the past 12 months, the commodities index has followed inflation closely, while the gold price has stalled. Indeed, on a five-year rolling basis, there have been periods when each of the options has been most correlated to an increase in the CPI.
Moreover, the portfolio approach came a close second in terms of risk-adjusted performance. Figure 3 helps visualize this by superimposing the portfolio return series onto the commodity index return series and the year-on-year inflation rate.
Figure 3. The Portfolio Approach Has Provided More Stable Inflation Mitigation
Source: Bloomberg, Neuberger Berman. For the indices used and the portfolio construction method, see the note to figure 2.
We can see the runups in the portfolio’s performance during commodity price rallies, such as 2003 – 2008 and over the past year, as well as some shared downside risk when commodities have sold off, during periods such as 2008 and the 2020 pandemic. Nonetheless, what stands out is the much more consistent performance generated in the immediate recovery from the 2008 – 09 financial crisis and the following years.
The available historical data suggests that upticks in U.S. CPI have been positively correlated to commodity futures, precious metals, equities in the Energy, Agriculture and Mining sectors, and to some extent REITs.
We find that combining these asset classes into a model portfolio appears to have been a more reliable way to mitigate against rising inflation than picking any one of them. The diversification effect in our model portfolio has appeared to boost risk-adjusted performance while preserving strong upside potential.
Much of the upside performance in the model portfolio has come due to the presence of equity exposure in the mix, which continued to perform well during the moderate inflation of the post-financial crisis environment. This is an important point for an asset allocator to consider, as it potentially makes it less onerous to shift into an inflation-protected portfolio; for example, a 60/40 investor seeking to mitigate the impact of higher inflation could rotate some of its equity exposure into more inflation-resilient sectors, while replacing some of its fixed income with a mix of gold, commodity futures and real estate securities.