Risk Parity portfolios are all about having multiple, dissimilar asset classes to create a portfolio that can weather any economic environment. Lately, in the US, that environment has been inflationary, with levels of rising prices not seen since the early 1980s. This got me thinking… how are the supposed inflation hedges faring?
Periods of high inflation are an odd time for most investors. Patterns of growth and decline are understood, and investors generally know which assets to invest in and which to avoid. Inflation, though, presents a less clear-cut choice, mostly because it really hasn’t been much of an issue in a long time. There really hasn’t been a period of sustained high inflation since the end of the 1970s and early 1980s, and many investors these days weren’t investing back then, and some weren’t even born yet. Over the past forty years, investors have generally seen inflation as predictable and modest, typically around 2%, with just some months over 3% (annualized) in the past forty years and very few over 4%. Ho hum, no big deal.
Until now, that is. For a variety of factors: supply chain disruption, expansion of the money supply to respond to the pandemic, the invasion of Ukraine, and others, inflation is now front and center. The inflation rate for the twelve months ending in February 2022 was a whopping 7.9%, the third consecutive month over 7%, the fifth over 6%, and the tenth month over 5%. Here are the numbers from BLS data:
Attention now turns to how investors can deal with this new factor:
The Asset Classes
To test, I looked at six asset classes (well, five, but two types of stocks) that represent the conventional wisdom about which asset classes can survive, or even thrive, in a high-inflation environment:
Stocks: Inflation is not necessarily the best suited asset class for inflation, but with the ability to raise prices, equities may be able to grow enough to stay a step or two ahead of stocks. In the 1970s, for example, stocks didn’t do that badly, overall, in nominal terms, though when looking at inflation-adjusted returns, they weren’t all that great. Among equities, small cap value stocks did better in that environment than other types, perhaps because they were more affordable in the first place, or perhaps because they tend to represent sectors of the economy (such as financials, industrials, and consumer discretionary) that can respond to higher prices.
Real Estate: by somewhat the same logic. real estate seems like it could do well. REITs can adjust rents as conditions change, and if long-term debt carries a low interest rate, then real estate can be more profitable as rents rise while debt payments stay the same.
Gold: Inflation is fundamentally a story of cash not going as far as it used to, so some have looked to gold as an inflation hedge. Theoretically, it seems like it would, but the record on gold as an inflation hedge is mixed: sometimes yes (the 1970s) but sometimes not.
Commodities: The connection here is obvious - inflation is the rise of prices of oil, wheat, corn, copper, etc. as those commodities become part of our purchases. Owning a broad basket of commodities would allow you to benefit from rising prices, hopefully at least as much as you were paying for higher prices.
Treasury Inflation-Protected Securities (TIPS): The intention of these is in the name as they were expressly designed to provide investment returns that will stay ahead of inflation. “TIPS are indexed to inflation in order to protect investors from a decline in the purchasing power of their money,” says Investopedia. So of course, this is the asset most likely to survive and thrive, right?
To represent the assets, I used VOO and VIOV to represent equities, and small cap value stocks, respectively, then VNQ for real estate, GLDM for gold, PDBC for commodities, and VTIP for TIPS. I made sure to include dividends and other distributions in the investigation to include all the upside of TIPS, REITs, and commodities, especially.
I then looked at three different time frames:
- Since April 2021, when inflation first poked upwards, going from 2.6 to 4.2% and staying elevated since.
- Since October 2021, when inflation first surpassed 6%.
- Finally, since December 2021, when inflation has surged to above 7%.
What can we draw from this experience of dealing with high inflation the past year, and the past 3-5 months, especially? Nothing definitive, since it is after all still a very small sample size, and performance with any sort of delayed signal might show up later. In addition, this is just a simple study of how the performance of each asset coincides with inflation; I have no commentary on causality.
But, it does seem pretty clear that commodities have been the best asset to handle inflation. The returns have been nothing short of outstanding. The test portfolios that have larger commodity allocations such as the Levered Butterfly, the RPC Growth, and the RPC Income portfolios, have been buoyed by PDBC’s surge in the midst of other asset classes (such as Long-term Treasuries which have declined). Looking long term, its clear that commodities should have a place in a risk-balanced portfolio. At a time when stocks have mostly retreated and Treasuries have bombed, it has been nice to see commodities pick up the slack.
Gold has lived up to its potential as an inflation hedge this time (so far), and real estate has also fared pretty well. Small cap value stocks and the stocks of the S&P 500 fund have not responded all that well, though small cap value stocks do seem to be gaining a bit as inflation persists and strengthens. This might be a case of a delayed response, as well, and we might see small cap value perform well as adjustments to prices are made.
And TIPS, good ol’ TIPS…yikes.
This was supposed to be their golden moment, the time when holding them was going to pay off. Not only have they underperformed just about every other asset, they have tended to do worse as inflation has gotten worse. For the past 3 months, when an investor would look to them most to provide relief, they have returned negative .27%. TIPS have one job, and they appear to be utterly incompetent at it.