Long-term view essential in fight against inflation

The Bank of England’s recent decision to pump another £50bn (€60bn) into Britain’s struggling economy rekindles some of the dilemmas posed by the aftermath of the 2008 financial crisis. How inflationary is quantitative easing? In the current low-growth, deleveraging environment, how should investors balance short-term deflationary with potential long-term inflationary risks?

Demand for safe haven assets has surged, but are equities under threat from inflation, or are they a hedge against it? And how do they compare to bonds, gold and property?

Analysing data spanning 112 years and across 19 countries, Elroy Dimson, Paul Marsh and Mike Staunton from the London Business School provide some interesting insights.

One of the key findings, published in this year’s Credit Suisse global investment returns yearbook, show that, historically, equities have been inflation beating but have been a poor hedge against inflation. Equities generated very disappointing real adjusted returns (-12 per cent) when inflation rates were high, at least 18 per cent, although they delivered good returns during low inflation.

It is, however, important to draw a distinction between an inflation-beating strategy versus an inflation-hedging strategy, says Professor Dimson. The former is a strategy which generated long run returns in excess of inflation, but this superior performance may be a reward for exposure to risk that has little or nothing to do with inflation, as it is in the case of equity risk premium.

An inflation-hedging strategy, on the contrary, provides higher nominal returns when inflation is high and it has a high correlation with inflation. This means it does well when inflation shoots up and badly when it goes down, with some sense of reliability, he says.

However, the long run performance of such an asset which provides an insurance against inflation may be low. For example, inflation-linked bonds potentially offer an excellent hedge against inflation but low long run return. Today, real yields for 10 year “default-free” index-linked bonds, issued by the UK, US, Canadian and Swedish governments, offer “historically low” returns, close to or sub-zero.

Bonds, on the other end, are very sensitive to inflation. A rate of inflation that is 10 per cent higher is associated at the margin with a real bond return that is lower by 7.4 per cent. However, bonds have a special role as a hedge against deflation.

ALL THAT GLITTERS

Gold as a store of value is the only asset that does not have its real value reduced by inflation but is very volatile, notes Professor Dimson. If it were a reliable hedge against inflation, its real price would be relatively unwavering.

“Investors need a very long horizon and, if history were to be repeated, tolerance to low returns with regards to gold, which is a non income producing asset.” In periods of deflation, it has been a useful asset to hold, he says.

House price rises are quite resistant to inflation, and historically have gone down in real value by about one fifth of the amount by which prices have risen.

The charts below show that indexing bonds are the best hedge against inflation. Equities have given a large risk premium, but are the most volatile of assets and are not a hedge against inflation.

Currency hedging is another key question posed by the current environment, as exchange rate changes can significantly boost or erode returns. Historical analysis shows that currency hedging reduces short-term volatility, but for equities it has a limited role for longer-term investors, as diversification benefits outweigh added currency risk. Currency hedging is far more effective for bond portfolios, as currency risk outweighs global diversification benefits.

Even if investors can forecast currencies, tilting asset allocations towards countries expected to have strong currencies and away from those expected to weaken is not the best way to exploit it, according to the study.

Instead, it is better to trade directly in the currency market. By using a currency overlay, the desired allocation across assets and countries can be left intact.