In our comprehensive paper ‘Inflation Hedging in Strategic Asset Allocations: Gold or Something Else?’ we seek to answer the following questions:

Question 1. Does inflation only matter to investors with liabilities denominated in real US dollars?

Answer 1. No. We find that the hedge/no hedge decision does not depend on whether investor liabilities are denominated in real or nominal US dollars. In the paper we will show that high inflation periods are almost as bad on a nominal basis as they are in real terms, particularly when the cash return is zero.

Question 2. Is gold an effective option for investors who want to hedge inflation?

Answer 2. Empirical evidence shows gold may not be a reliable inflation hedge. We believe there are some broad commodity investing approaches that are more likely to deliver good results. The key point of the paper is that investors relying on precious metals to hedge inflation could be disappointed. Our estimates suggest inflation surging to 5% would lead to precious metals performance of roughly cash plus 5% (cash plus 0% on a real basis), whereas well-crafted, broad commodity portfolios could earn more like cash plus 15% in such an inflation surge. In addition, broad commodity exposure can be designed so that it still works in disinflationary environments, with expected returns of cash plus 3.5% in a 2% inflation world.

Question 3. How can we build a strategic asset allocation that accommodates multiple inflation scenarios?

Answer 3. One effective method is to shift historical means of asset returns and inflation to reflect forward-looking investment views, then build optimal portfolios based on the new distribution of asset and macro data. We provide a basic example of how to do this in the final section of the paper. One result that stands out is that the low expected return on bonds today makes the opportunity cost of owning inflation-sensitive assets much lower than it has been historically, and increases the optimal exposure to these assets across multiple portfolio objectives.

Detailed Historical Analysis

The paper also provides perspective on real returns of stocks and bonds during the inflationary episodes of the 20th and early 21st centuries by first identifying periods of high inflation and then examining the performance of stocks and bonds during these periods. Consistent with the typical narrative, both stocks and bonds generate a negative real return during most inflation episodes. But, importantly, they also underperform cash in these environments, making inflation hedging an important concept, even to investors with objectives denominated in nominal terms.

With this in mind, we extend the analysis to the performance of gold, broad commodities, and Treasury Inflation-Protected Securities (TIPS) back to the early 20th century. We find that broad commodities performed a bit better than gold on average during inflationary episodes, and gold was only really helpful during the inflation episodes in the 1970s. TIPS were good at hedging their own cash flows against inflationary pressures and outperformed cash on a real basis, but the outperformance was not so material that an investor could use TIPS to hedge their broader portfolio against inflationary shocks.

Next, we take a deeper look at gold performance during inflationary episodes, with an eye toward understanding why it was so strong in the 1970s but has seemed much less related to inflation since then. Statistically, the correlation between gold prices and inflation was strongly positive in the 1970s (+0.36), but has been virtually uncorrelated (-0.03) since 1981 (Bloomberg, accessed 10/1/21). It is important to note that gold’s strong performance came in the decade after the gold standard was abandoned, when the US dollar depreciated tremendously against gold. All developed-market currencies that were part of the Bretton Woods system depreciated relative to gold during the adjustment period. We think this is an important detail to keep in mind and we include a detailed discussion of it in part three of the paper. The conditions that made gold work so well in the 1970s are simply not present today.

Commodities that comprise the raw materials put into production processes have had a much more reliable relationship to inflation that has persisted throughout the historical period of study. Statistically, the correlation between broad commodity prices and inflation was strongly positively correlated to inflation before 1980 (+0.35) and has been similarly strongly correlated since 1981 (+0.31) (Bloomberg, accessed 10/1/21). The problem with broad commodities is that they have generated low or even negative returns over the last three-plus decades, a period during which the US has experienced very little inflation.

In the final section of the paper we use standard portfolio construction concepts and some first principles of commodity futures markets to design what we believe to be a structurally superior commodity strategy that has the potential to generate returns in the neighborhood of cash plus 3% in a benign inflation environment, with expected returns that scale at over three to one relative to inflation, and an expected nominal return of cash plus 30% if inflation hits 10%. Precious metals, by comparison in the same framework, are expected to generate cash plus 4% in a benign inflation environment, with a nominal return of cash plus 7% if inflation hits 10%. If history is a guide, precious metals may almost keep up with inflation but will not provide a substantial hedging benefit to a broader portfolio.

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