Inflation has become a top-of-mind topic for clients in recent months, with many exploring ways to position for potentially higher inflation in the period ahead. However, after a decade of “disinflation,” we believe the investment community continues to anchor to the prior regime and to some stubborn misconceptions around inflation hedging. Here are five that could prove costly if, in fact, inflation does rise.

 

Misconception #1: You can wait to allocate to inflation hedges until we have higher inflation.

Reality: Timing when to buy inflation-related assets is just as difficult as trying to “market time” any other type of investment. That’s why investors are advised to hold strategically diversifying assets like stocks and bonds and, in our view, should also own inflation-sensitive assets as a long-term, strategic portfolio allocation. As with any asset, the fundamentals are already priced in ahead of time, making waiting for the “right time” challenging at best and futile at worst.

 

Misconception #2: Commodities earn next to nothing, so why even bother with them?

Reality: Given that commodity spot prices roughly kept pace with (or even outpaced) the Consumer Price Index over the long term, their yield should be thought of as a “real” (inflation-adjusted) yield.

Commodities’ yield comprises both the collateral yield (effectively zero for the foreseeable future) and the roll yield. The latter was a major headwind during the recent disinflationary cycle, which many investors have extrapolated into the future. During inflationary cycles, however, the roll yield can be persistently positive, which (when compounded with rising spot prices) has led to strong commodity returns.

 

Misconception #3: Equities are all you really need as an inflation hedge.

Reality: Despite their many potential benefits, equities have historically proven to be poor inflation hedges. That’s because rising inflation has historically created tighter monetary policy, greater economic uncertainty, and higher input costs, all of which tend to be headwinds for corporate earnings and equity valuations. While equities have struggled with inflation shocks, the myth that equities are an effective inflation hedge stems from their historically positive long-term real returns during high-inflation periods. However, returns during these periods have been much lower than in “non-inflation” periods.

Additionally, today’s lofty equity market valuations are at least partly due to subdued inflation, allowing interest rates to stay low and government policy accommodative. As a result, rising inflation would pose a clear risk for core equities.

 

Misconception #4: Real assets and inflation hedges are the same thing.

Reality: From here, some real assets will likely be better inflation hedges than others. For example, longer-duration real assets with stable cash flows may be susceptible to underperformance if higher inflation causes interest rates to rise, while others may offer significant operating leverage to rising prices. The real assets that performed well over the last disinflationary decade typically exhibit low sensitivity to inflation, raising the risk that they may not function as inflation hedges when needed.

 

Misconception #5: Commodities aren’t particularly relevant to today’s economy.

Reality: Figure 1 (historical inflation versus commodity returns) shows that commodities remain highly relevant for economy-wide prices. Even amid excitement over the upcoming spending wave on “green” energy, new drivers of commodity demand are emerging, as batteries require nickel, electric-vehicle charging stations utilize copper, and wind turbines need iron ore. The scale of this demand is amplified by inadequate production potential after a decade of underinvestment in the mining and energy sectors. What appears to be a cyclical rebound in commodity prices could be more structural in nature.

The Bloomberg Commodity Indices (BCOM) are a family of financial benchmarks designed to provide liquid and diversified exposure to physical commodities via futures contracts. The principal potential benefits of including commodities in a diversified financial portfolio include positive returns over time and low correlation with equities and fixed income

Final thoughts

Investors may be surprised how “inflation-exposed” their portfolios have become following a decade of disinflation. Now may be an opportune time to revisit traditional inflation hedges. 

This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.

The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.

This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.

“New York Life Investments” is both a service mark, and the common trade name, of certain investment advisors affiliated with New York Life Insurance Company.

New York Life Investments engages the services of Wellington Management Company, LLC, an unaffiliated, federally registered advisor.

Disinflation is a decrease in the rate of inflation – a slowdown in the rate of increase of the general price level of goods and services in a nation's gross domestic product over time

Roll yield is the amount of return generated in the futures market after an investor rolls a short-term contract into a longer-term contract and profits from the convergence of the futures price toward a higher spot or cash price.

IMPORTANT DISCLOSURE

The views expressed are those of the author and are subject to change. Other teams may hold different views and make different investment decisions. While any third-party data used is considered reliable, its accuracy is not guaranteed. Forward-looking statements should not be considered as guarantees or predictions of future events. The value of your investment may become worth more or less than at the time of original investment. Past results are not a reliable indicator of future results. Commentary provided should not be viewed as a current or past recommendation and is not intended to constitute investment advice or an offer to buy or sell securities. Wellington assumes no duty to update any information in this material in the event that such information changes.

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