Jun 12

Managing Inflation Risk…advisers have it wrong

Source: van Eyk Research

The above poll was taken by van Eyk Research on their subscription website. In terms of the sample, it is large (848 responses) so may be statistically representative of van Eyk subscribers whom I can only assume is financial advisers, researchers, and maybe fund managers. As shown almost 1 in 2 respondents believe equities offers the best protection against inflation, but unfortunately empirical analysis (that I and a few others have performed) show that equities definitely does not offer the “greatest protection against inflation risk”.

Over the last 140 years, there are two major periods of time where inflation was particularly high in the US…

  • During WWI, 1914-1919, where CPI averaged 13.3%pa, and
  • 1971-1981, where there was significant monetary expansion and high energy prices (including the oil shock of 1973-74) and CPI averaged 8.3%pa

As you would expect, inflation is a disaster for traditional bonds (government) and their returns over these two periods were a disastrous 2.1% and 3.8%, respectively. We all know that when inflation increases, so too does bond yields, hence prices decrease.

Unfortunately for (potentially) almost 50% of advisers, equity returns of the S&P500 only returned 11.6% and 5.8% respectively…failing to keep up with inflation whatsoever. So much for a decent hedge.

The asset classes that performed best were…

  • Housing…17.5%pa and 12.1%pa (National Association of Realtors)
  • Farmland…14.7% and 14.6%pa (NCREIF Farmland Index)
  • Gold…no data for WWI and 28%pa during 1971-81 (Spot Gold Price)
  • Silver…15.5%pa and 21.5%pa (Spot Silver Price)

and, given inflation linked bonds would have paid a premium to inflation, obviously they also would have outperformed inflation unlike equities!

Floating Rate Securities were a mixed bag over these two periods, whereby the Ibbootson Commercial Paper index, provided returns of 4.7% during WWI (clearly underperforming both CPI and Equities) but provided a solid 8.8%pa during 1971-81, outperforming both CPI and Equities.

So, it looks like adviser have fallen for the good old marketing campaign that the Australian Financial Services industry has pedaled for a long time, that equities solves all. Unfortunately I believe the results above are a reflection of the fact that Australian advisers have very little selection for their clients in terms of commodities and inflation linked bonds hence the equity bias.

So when do equities perform best…when there is disinflation/moderate inflation or when there is price stability. Deflation, is also disastrous for equities. Given the debate around whether the US will enter high inflation or deflation it sort of makes sense why equities have gone nowhere.

Reference: Darst, David (2008), The Art of Asset Allocation, McGraw Hill


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