Inflation Revisited
Asset class performance during the recent inflation spike
Three years ago, we wrote a timely, weekly research piece on inflation, which explored our views on which asset classes tend to perform best in high-inflation environments. One of our primary conclusions was that commodities and gold experienced the highest average annual real returns during rising inflationary periods while 10Y US Treasurys performed the worst. One of the summary charts is shown below.
Figure 1: Inflation Beta and Avg Annualized Real Returns by Asset (1970-2020)
Source: Verdad analysis, CapitalIQ, Bloomberg, FRED
Since writing that piece, inflation (as measured by the Cleveland Federal Reserve) increased from 1.44% annualized to 6.48% in October 2022. It has gradually declined and the current Nowcast sits at 3.72% as of April 2024.
We thought it would be worth revisiting what has and hasn’t worked over this roughly three-year period of elevated inflation and how those results compare with our initial findings.
We show below how a subset of the asset classes listed above performed with various starting points that might have served as inflation “alarm bells” (we show a variety to avoid hindsight bias or cherry picking). For our inflation signals, we consider the below indicators, each of which captures information and expectations about inflation over different time horizons.
Cleveland Fed Inflation Nowcast Core CPI MoM
US 2Y Breakeven Inflation (2Y TIPS – 2Y UST)
US 5Y Forward Breakeven Inflation (Nominal 5Y Forward – TIPS 5Y Forward)
Figure 2: Cumulative Asset Class Returns (Ending 4/24/2024)
Note: Oil (CO Futures), Gold (GC Futures), Copper (HG Futures), S&P (ES Futures), UST (TY Futures), TIPS (Bloomberg US TIPS Total Return Index)
Source: Bloomberg; Verdad analysis
Regardless of the starting inflation trigger, we observed that oil and gold performed the best, in our opinion, with equities next. Copper generally had middling performance, TIPS delivered unsatisfying returns, and 10Y Treasurys were consistently the worst performer.
These results are consistent with our prior research, in which we forecast commodities and gold to be the best performers in inflationary periods and 10Y Treasurys to be the worst, in our opinion.
The lackluster performance of TIPS is perhaps surprising, given that they are designed to protect against periods of elevated inflation (hence the name Treasury Inflation-Protected Securities). However, TIPS yields are in effect the real rate, and they respond to changes in the real rate in the same way that Treasurys respond to changes in the nominal rate. TIPS work best in a stagflationary environment where real rates decline and inflation increases. Since March 2021, inflation has increased 18% and real rates have increased from 0% to 2%. For TIPS with a duration of 10 years, the change in real rate, multiplied by duration (-2% * 10 = -20%) more than offsets the increase in inflation (+18%), leaving investors with not a lot to show for their investment (-2% total return).
Returning to the worst performer, 10Y Treasurys, the underperformance underscores the inadequate protection that a traditional 60/40 portfolio offers during inflationary periods. As we’ve shown previously, bond correlation with equities tends to increase in inflationary periods, decreasing the diversification benefit that investors expect a bond allocation to play.
Figure 3: 3Y Trailing Stock-Bond Correlation vs. Avg. Core Inflation (1929–2023)
Source: Bloomberg; SBBI Ibbotson US Large Stocks and US LT Govt prior to 1989; Verdad analysis
Investors who had diversified an equity portfolio with an allocation to either oil or gold and sold out of 10Y Treasurys would have fared much better over any of the periods shown in Figure 2.
When to reverse these pro-inflation allocations is an open question. With the Cleveland Fed Nowcast registering 3.72% and the 2Y and 5Y breakeven rates both at ~2.45%, we are not out of the inflation woods yet. Historically, we’ve seen, the path from 3% to 2% inflation has been circuitous and riddled with false summits.
With respect to raising rates to combat rising inflation, both Paul Krugman and Larry Summers suggested the Fed wait until it saw “the whites of inflation’s eyes.” We believe investors should take a similar approach with respect to disinflation when it comes to exiting inflation hedges, which we believe have proven invaluable over the past three years.