Although this recent inflationary period has been very short, some observations can be made that may provide investors some perspective on how various assets may perform if elevated inflation rates persist.
“Consensus” inflation assets
The consensus inflation assets (gold, commodities, and TIPs) provided anything but consistent protection from inflation. Not surprisingly, commodities did perform exceptionally well. However, the surge in commodity prices was aided by the very unusual combination of factors affecting the global economy, such as the pandemic, the war in Ukraine, and China’s suspension of its lockdown policies. Furthermore, as fears of a recession have grown, commodity prices overall have come down since peaking last year. That being said, almost by definition, commodities typically perform well during periods of persistent inflation.
Gold, as a subset of commodities, surged initially as inflation rates rose, but experienced significant volatility through most of 2021 and 2022. It hit a three-year low in October 2022 before surging about 20% through the end of April 2023. But, in all, gold has provided only modestly higher returns than cash invested in a money market fund since the beginning of 2021. Gold does have a history of providing very long-term value preservation, but as an asset without income, it is challenged in providing real inflation-adjusted growth.
TIPS were not a great hedge during this burst of inflation either. Although TIPs performed meaningfully better than the broad bond market, they still had negative returns in an environment that saw both nominal and real fixed income yields surge in response to the unexpected jump in inflation. However, now that yield levels have been reset after the Fed’s aggressive tightening campaign, 10-year TIPs have been trading recently at a real yield of about 1.3%.
Other potential inflation assets
Real estate has been considered a potential beneficiary of inflation. However, a distinction must be made between residential and commercial real estate. Residential real estate prices surged initially as inflation rates rose, but home prices peaked in June 2022 and have fallen about 5%ii since then in response to rising mortgage rates. Rental rates have also leveled off after a sharp spike in 2021 and 2022. Commercial real estate and REITS also performed well initially in response to concerns over inflation. However, the twin issues of rising interest rates and the secular shift to remote work policies reversed this trend, leading to significant underperformance over the past year. Going forward, these twin issues will continue to create headwinds for commercial real estate and REITS.
As for crypto currency, and Bitcoin specifically, it failed as a hedge against inflation, experiencing heightened volatility over the past two years.
Cash, invested in a traditional money market fund, which has historically been less risky than equity and bond investments, provided a rather modest return, while exhibiting no volatility. Although very simple and unglamorous, money market funds, with current yields of roughly 4.5%, will continue to be attractive, especially for the very low risk component of an investor’s portfolio. If inflation unexpectedly moves higher again, forcing the Fed to raise short term rates further, money market yields may also increase.
Not surprisingly, long-term bonds suffered significantly as inflation and interest rates both surged higher. However, it is likely that the Fed will soon pause in its aggressive policy stance, which may provide some stability to the bond market and potentially improving performance prospects. If inflation continues to move lower, we believe that bonds would provide annualized returns in the range of their current yields of 3.5-5.0%, depending on maturity and credit quality.
The stock market performed surprisingly well during the first year of rising inflation, but ultimately succumbed to the realities of persistent inflation, higher interest rates, and growing fears of recession. Although stocks have rebounded somewhat in 2023, corporate management teams are clearly pivoting to strategies that address these inflationary pressures. The ability to stem rising costs through productively enhancements or right sizing operations will be critical to supporting profitability. Persistent inflation could contribute to continued stock market volatility in the short term. Longer term, corporate managers have multiple levers that can be used in response to inflation.
Although the recent burst of inflation has been relatively short in duration, it does provide some insight into how various assets might behave if inflation remains persistent. The recent performance of several assets that historically have been considered inflation hedges provided little if any incremental benefit over a conventional portfolio of stocks, bonds, and cash. The exception is commodity assets. However, it is difficult for many investors to easily access the commodity markets directly. Most securities that provide a vehicle for obtaining exposure to commodities are dependent on the commodity futures market, which has its own idiosyncratic complexities and risk.
Our current view is that inflation will continue to abate, but that it will not reach the Fed’s goal of 2% over the next year. Thus, inflation will continue to have a significant influence in the capital markets, but not to a degree that requires wholesale asset allocation changes or special allocations to assets that historically have been considered inflation hedges. The recent performance of these perceived inflation hedge assets largely supports this approach.