This is true for investors with liabilities explicitly linked to inflation, like Defined Benefit plans, as well as those with more implicit linkages, such as Defined Contribution plans aiming to fund comfortable retirement lifestyles for their members.
When evaluating inflation protection in the portfolio context it is crucial to consider exactly what type of risk the investor is trying to protect against. Certain assets may do a good job of preserving purchasing power over the long-term, but are ineffectual at protecting against the short-term re-rating of risk assets or discount rates that often accompanies unexpected spikes in inflation.
As an example, inflation-linked bonds (ILBs) are often the first asset that comes to mind when investors think of inflation-hedging assets. But how well did ILBs perform throughout the recent inflation surge? In the 12 months to 30 June 2022, which marked the recent peak in annual inflation growth in the US, the broad-based iShares TIPS Bond ETF (TIP) returned -5.3%, delivering a real return of -14.3%.
ILBs sold off over the year because real yields widened significantly, and changes in real yields typically explain the majority of short-term volatility for ILBs. So while ILBs may provide an effective long-term hedge against inflation, they do not necessarily provide any protection at all in the short-term.
If an investor is interested in hedging their portfolio against volatility associated with short-term spikes in inflation, what then are their options? To answer this question we looked at the returns of several asset classes often touted as offering protection against inflation through a risk factor lens. For this analysis we used a simple set of three risk factors covering equity risk, changes in real yields, and inflation. The asset classes we looked at were listed real estate, commodities, gold, and short-duration ILBs.1
Figure 1 shows the correlation of the factor series over the 24 months from 31 December 2020 to 31 December 2022, during which time inflation reached a multi-decade high. The equity and real yield factors, which are often dominant in traditional investment portfolios, were relatively correlated over this period, and less so with the inflation factor.
Figure 1: Factor correlations
Source: Jacobi, Morningstar. Past performance is not indicative of future results.
Figure 2 shows the betas of our asset classes to the factors after performing a backwards stepwise regression and only retaining those factor exposures that are statistically significant at the 5% confidence level.
Figure 2: Regression betas
Source: Jacobi, Morningstar. Past performance is not indicative of future results.
Only commodities showed any significant loading on the inflation factor over the horizon assessed. And even when extending the analysis back five or even ten years, commodities remain the only asset class to demonstrate a high beta to the inflation factor. So if an investor is wishing to protect against short-term portfolio fluctuations associated with unexpected inflation, they may need to closely consider which inflation-hedging assets they include in their portfolio.
This is not to say that real estate, ILBs or other traditional inflation-hedging assets fail to preserve purchasing power over the long term. Having cash flows linked to inflation through CPI-linked rent increases, or through principal indexation, is an obvious way to hedge the long-term inflation risks inherent in many liabilities. But it does highlight that investors need to be aware of the different impacts that inflation can have on portfolios or liabilities over different horizons, and invest accordingly.
1The returns of listed real estate, commodities, gold and short-duration ILBs were proxied by the returns of the following broad-based ETFs: Vanguard Real Estate Index Fund ETF Shares, iShares S&P GSCI Commodity-Indexed Trust, SPDR® Gold Shares and iShares 0-5 Year TIPS Bond ETF respectively.
