Inflation Hedges: Fact and Fantasy

Equity markets have clearly taken notice of rising inflation—and not in a good way. Here, Gene Podkaminer and Chris Ratkovsky of Franklin Templeton Investment Solutions explore how different investments have performed during various inflation scenarios, which strategies or asset classes might provide an inflation hedge, and whether a “soft landing” economic scenario is possible.

Since 1983, inflation in the United States has been relatively tame. Until recently, it hovered around 2% on an annualized basis. The effects of high inflation on the health of an economy are well understood. Unexpected inflation hurts creditors, because they are later paid back in currency that is then worth less. It is destructive to capital formation, because it makes capital suppliers (creditors) hesitant to lend money. However, the effects of inflation shocks (changes to current inflation or inflation expectations) on asset classes, rather than economies, are not as well known. Here, we focus on some of the key lessons we’ve learned from history.

The typical 60/40 portfolio

Conventional wisdom has traditionally said different things about how equities and bonds should behave in an inflationary environment—some hold to the notion that stocks should be protected from high inflation. But as we know, theory does not always hold up to reality.

Traditionally, some academics and investors believed that the real value of a firm should have nothing to do with inflation from first economic principles, as firms are in the business of buying real assets—factories, trucks, labor contracts, patents—and selling real assets (consumer or producer goods and services). However, during the “Great Inflation” of 1965-1982, stocks did not earn their risk premia—they returned less than Treasury bills (an oft-used proxy for cash). Using economic principles, we surmise that unexpected inflation is bad for equities, at least in the short term. It causes a double whammy on equities: (1) higher nominal discount rates, and (2) the fact that companies cannot always raise selling prices fast enough to compensate for their rising wage and other costs.1

Over the long term, stocks may find some support if companies are able to make gradual adjustments to pass on higher input costs to consumers in the form of higher prices—not necessarily enough to turn large profits (thrive), but enough to survive. Eventually, economies tend to revert to a demand/supply equilibrium; soaring prices should dampen demand, which in turn normally forces prices lower. Demand then recovers. In this type of disinflationary phase, stocks could also do well, much as they did in the early-mid 1980s.