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In the long-term performance race against inflation, stocks are the hands-down winner, outpacing inflation 9.7% to 3.0% since 1926.  But that history is characterized predominantly by modest inflation, with one big exception – the 1970s, when double-digit inflation contributed to a bear market. 

As the government prints more money to finance rapidly expanding budget deficits, every investor must prepare for a possible return of 1970s-style inflation.

In theory, equities should perform well during inflation.  They represent real assets, and as the prices of these assets rise, so should equity prices. 

In this case, though, history and theory are at odds.

A working paper by two economists at the International Monetary Fund, “Inflation Hedging for Long-Term Investors,” provides the latest evidence that equities aren’t an effective hedge against inflation.  Its authors, Alexander P. Attié and Shaun K. Roache, conclude that commodities and – surprisingly – nominal bonds have inflation-fighting characteristics that equities lack, but their performance is greatly dependent on the investment horizon.

Attié and Roache looked across a range of asset classes to see which have hedged against inflation effectively.  They measured the returns for cash, equities, nominal bonds, real estate, commodities and diversified portfolios against inflation over a one-year time frame and over longer time horizons. 

Inflation Hedging over a One-Year Period

For the one-year test, Attié and Roache used a regression to measure annual returns for each asset class against actual (“ex-post”) inflation.  They did not attempt to determine the effect of inflation surprises; instead, their goal was to measure performance over a one-year period – the time span over which manager performance is often measured.

Commodities were the most effective hedge over the one-year period, with the CRB index, the GSCI total return index and the spot gold price posting economically and statistically significant outperformance.  For each one-percent increase in inflation, those commodities increased between 3.8% and 10%.

Nominal bonds performed poorly, losing up to 3% for every 1% increase in inflation. 
Equities were an ineffective hedge – U.S. large cap equities lost a statistically insignificant 0.03% for every percentage increase in inflation, and a diversified basket of international equities lost 3.5%.

Cash also failed to keep pace with inflation.  US-denominated cash lost 0.24% and global cash lost 0.65% for every percentage-point increase in inflation.  The authors note that this is a “puzzling result,” since cash should track inflation very closely, and they warn against “the dangers of concluding too much from simple regressions and the importance of testing for model stability.”  They explain that these curious results for cash were heavily influenced by the 1980-82 period, when interest rates continued to rise even after the effects of the second-round oil shock and headline inflation began to abate. 

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