In focus

Where to find shelter from rising inflation


The Covid-19 crisis has resulted in enormous fiscal and monetary stimulus while also destroying capacity in some sectors of the economy. This has led some investors to believe we are on the cusp of a rise in inflation. We analyse the impact of this potential scenario on seven asset classes and find that while some of them have desirable inflation-hedging properties, their ability to generate positive real (inflation-adjusted) returns varies over time. Whichever inflation scenario unfolds, traditional equity and bond investors face the greatest risks and cannot afford to be complacent.

In the wake of Covid-19, investors have started debating whether long-dormant inflation risks will soon resurface. The fear is that the historic fiscal and monetary response to the pandemic, combined with the disruption it has inflicted on supply chains, could exert upward pressure on the overall rate of price increases for goods and services once economic activity normalises. This would bring an end to the era of low inflation that we have grown accustomed to over the past three and a half decades.

Markets are slowly waking up to this possibility. Inflation expectations, as measured by the yield difference between nominal and inflation-protected US Treasury bonds, have rebounded sharply from their pandemic lows. They are now just above their average of 2% seen for the past decade. But if inflation expectations rise even further, then markets could react unfavourably. For example, in the past, equities and bonds posted negative real (inflation-adjusted) returns more than half the time in periods of high and rising inflation. Clearly, there is a lot at stake and investors cannot afford to be complacent.

So where should investors look for effective inflation protection? To answer this question, we analyse the impact of inflation on seven asset classes: government bonds, equities, short-term bills, inflation-linked bonds, real estate investment trusts (REITs), commodities and gold. Our research finds that while some of these assets have desirable inflation-hedging properties, their ability to deliver positive real returns varies over time and arbitrarily selecting some of them may distort a portfolio’s risk profile.

Given the range of risk tolerances for different investors, there is no optimal approach that would suit everyone. In general, a balance must be struck between a desire for inflation protection and a tolerance for volatility. Depending on an investor’s asset mix and their assumptions about future market behaviour, it is possible, however, to incorporate inflation hedges into a portfolio without causing undue distortions to its prior risk profile.

Our analysis is based on all available market data since March 1973. This period captures the end of the Bretton Woods era and the shift towards the fiat monetary system that remains in place today. To keep the scope of this paper manageable, we focus on US inflation, as measured by the consumer price index (CPI), although the insights we provide are still relevant for global investors.

Inflation sensitivity

The first step to evaluating any prospective inflation hedge is to assess its responsiveness to inflation. We measure this by calculating the sensitivity of an asset’s total return to a change in the inflation rate over a one-year horizon, after controlling for the level of inflation. This is known as an asset’s “inflation beta.” All else equal, the higher an asset’s inflation beta, the more its returns have tended to increase when inflation has risen.

Figure 1 illustrates how inflation sensitivity varies significantly by asset class (see appendix for the list of indices used). Bonds and equities, for example, tend to respond negatively to rising inflation. For every 1% increase in the inflation rate (e.g. a rise from 2% to 3% over one year), US Treasuries and equities fell by 1.7% and 1.2% respectively. In contrast, gold and commodities exhibited very positive betas, suggesting they have historically rallied when the rate of inflation increased.

Figure 1: Inflation sensitivity varies by asset class

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Source: Datastream Refinitiv and Schroders. Data from March 1973 to December 2020, except TIPS from March 1997. Notes: based on a multivariate regression of rolling annual total returns of each asset class on the change in the inflation rate over one year (inflt+0 - inflt-1) and the inflation rate at the start of the year (inflt-1). *Not statistically significant at the 5% level using robust standard errors.

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