Inflation leaving you deflated?

In recent times we have observed a combination of supply-side shocks and a policy response that have reinforced each other to drive inflation to significantly elevated levels. The COVID-19 global pandemic wreaked havoc on supply chains and this was further compounded by the war in Ukraine. The much-needed policy response to the pandemic (loose monetary and fiscal policy to alleviate the strain on companies and households disrupted by lockdowns), in hindsight, looks like it remained in place for too long, driving consumer demand to levels producers have struggled to keep up with.

There are a range of factors that can influence inflation:

DEMAND
Rising consumer demand because of expansionary monetary or fiscal policy can push up prices
SUPPLY
Supply shocks can increase the cost of producing goods and services, which may be passed on to the end consumer
SHIFTS
Economic or geopolitical shifts, may be the underlying trigger

Double-digit inflation readings in the US in the 1970s and 1980s presented a difficult period for households, companies and the investment community. ‘The Great Inflation’, that started in the mid-1960s lasted for 17 years and was considered a failure of American macroeconomic policy . We are learning that elevated inflation cannot be resigned to the history books. In 2022, we are observing inflation rates that are very close to double-digit once again.

So, what can investors do to hedge inflation risk?

There are a number of asset classes and strategies that have, historically, performed well during inflationary periods. Commodities, gold and quality strategies are typically considered inflation hedges for this reason.

COMMODITIES

Historically, commodities have tended to move in tandem with inflation. While many other cyclical assets, like equities, react to ‘expected inflation’ (inflation expectations formed by strength of economy and monetary growth), commodities also tend to respond well to ‘unexpected inflation’ (inflation driven by unanticipated supply or demand shocks). As the demand for goods and services increases, the price of those goods and services rises, which inflates the prices of the commodities used to produce them.

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GOLD

Gold often acts more like a currency than a commodity but, unlike most fiat currencies, its supply cannot be increased. As such, it has a ‘super-haven’ status and is often considered an excellent store of value due to its desirability and moderate scarcity. When the purchasing power of cash is being eroded, investors often seek out hard assets, considered to have intrinsic value due to their finite supply.

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QUALITY

Quality strategies are often touted as ‘all-weather’ investments. They can help build wealth over the long term in periods of low volatility, whilst also being a defensive asset during economic downturns. Quality stocks are identified by their solid business models, strong brand positioning and financial strength. These attributes can help withstand inflation as their high pricing power often allows them to defend their profitability in a high-inflation environment.

Find out more about our Quality strategy

Sensitivity of asset classes to inflation

Broad commodities tend to rise with both expected and unexpected inflation. Gold tends to rise with unexpected inflation. Very few assets rise with unexpected inflation. US Treasury Protected Securities (TIPS) - an instrument designed for inflation protected - is inferior to broad commodities in this regard.

Sensitivity of major asset classes to expected and unexpected inflation

Source: WisdomTree, Bloomberg, S&P. From January 1960 to June 2022. Calculations are based on monthly returns in USD. Broad commodities (Bloomberg commodity total return index) and US equities (S&P 500 gross total return index) data started in Jan 1960. US treasuries (Bloomberg US treasury total return unhedged USD index) and US corporate bonds (Bloomberg US corporate total return unhedged USD index) data started in Jan 1973. Gold (physical gold) data started in 1968. US Treasury Inflation Protected Securities (TIPS) started in Apr 1997. Sensitivity is measured through the asset class beta with inflation (the higher the beta the more the asset tends to rise with inflation). In statistical terms, beta represents the slope of the line through a regression of the asset class returns and inflation. We proxy the expected inflation using the T-Bill interest rate. Unexpected inflation is the 'realised inflation rate' minus the T-Bill rate. Historical performance is not an indication of future performance and any investments may go down in value.

The importance of the ‘growth’ factor

Commodities and gold appear to do well in high inflation/strong economic growth scenarios. But even when economic growth falls (high inflation/low growth), commodities and gold have historically performed well relative to equities.

Source: WisdomTree, Bloomberg. From June 1961 to June 2022. Inflation based on US Consumer Price Index data. Growth based on the OECD composite leading indicator (CLI) which is designed to provide early signals of turning points in business cycles, showing fluctuation of the economic activity around its long term potential level. CLIs show short-term economic movements in qualitative rather than quantitative terms. CLI is amplitude adjusted, Long-term average = 100. Asset price calculations are based on yearly returns in USD. Broad commodities (Bloomberg commodity total return index) and US equities (S&P 500 gross total return index) data started in June 1961. US treasuries (Bloomberg US treasury total return unhedged USD index) and Gold (physical gold) data started in 1968. High inflation is when CPI inflation is above 3.5%. Low inflation is when CPI is below 1.5%. High growth is when CLI is above 101.4 for high inflation scenarios and 100 for low inflation scenarios (CLI threshold is lowered for the latter because of the low number of observations with inflation below 1.5 and CLI above 101.4). Low Growth is when CLI is below 98.6. Historical performance is not an indication of future performance and any investments may go down in value.

COMMODITIES

GOLD

QUALITY

Commodities

Historically, commodities have tended to move in tandem with inflation. For those looking to invest in commodities there are numerous options ranging from individual commodities to targeted or broad baskets.

Agriculture

Our suite of Agriculture products enables investors to gain exposure to individual commodities and baskets of agriculture commodity futures.

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Broad Commodities

Our suite of Broad and Enhanced Broad Commodities allows investors to gain broad exposure to commodities as an asset class.

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Energy

Our suite of Energy products enables investors to gain exposure to Oil and Natural gas, as well as baskets of Energy commodity futures

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Industrial Metals

Our suite of Industrial Metals enables investors to gain exposure to nickel, copper, zinc, tin, aluminium and lead, as well as industrial metal baskets.

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Livestock

Our suite of Livestock products enables investors to gain exposure to individual commodities and baskets of Livestock commodity futures.

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Precious Metals

Our suite of Industrial Metals enables investors to gain exposure to nickel, copper, zinc, tin, aluminium and lead, as well as industrial metal baskets.

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Inflation leaving you deflated?

There are a range of factors that can influence inflation:

DEMAND

SUPPLY

SHIFTS

So, what can investors do to hedge inflation risk?

COMMODITIES

GOLD

QUALITY

Sensitivity of asset classes to inflation

Sensitivity of major asset classes to expected and unexpected inflation

The importance of the ‘growth’ factor

Commodities

Agriculture

Broad Commodities

Energy

Industrial Metals

Livestock

Precious Metals