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Inflation, a significant long-term risk, can erode the purchasing power of investors and families. It’s a critical factor for wealth managers to consider as it can increase the nominal value of implicit liabilities or future spending, represented on the right-hand side of the extended family balance sheet. If the assets on the left-hand side of the balance sheet do not increase proportionately, inflation can gradually erode a family’s discretionary wealth. For instance, consider a family with a fixed income of $50,000 per year. If the inflation rate is 2%, the family will need an additional $1,000 the following year to maintain the same standard of living.
Less wealthy families, possessing fewer real assets and other inflation hedges, are more severely affected by inflation. This is primarily because inflation has a larger proportional impact on their lower discretionary wealth. For example, a family with a net worth of $100,000 will feel the impact of a 2% inflation rate more acutely than a family with a net worth of $1,000,000.
For wealthier families, the impact of inflation may not be as immediate or noticeable. However, over the long term, and particularly across generations, inflation can significantly erode the value of accumulated wealth. For instance, a family with a net worth of $10 million may not feel the immediate impact of a 2% inflation rate, but over 30 years, that rate could reduce their net worth to $5.4 million.
There are three primary types of inflation that economists identify:
Regardless of the order in which prices and costs rise in an economy, the root cause of inflation remains the same: excessive demands for raw materials, finished goods, or labor that exceed the economy’s capacity to respond. Early signs of inflation often surface in areas with the most constraints, such as the labor market, the commodities market, or some area of final output. Therefore, when considering inflation, practitioners look to indicators that might reveal when the economy faces such constraints.
Cost-push inflation is a specific type of inflation that arises due to an increase in the cost of production factors. These factors can include labor and commodities. For instance, if the price of oil, a key input in many industries, rises significantly, it can lead to an increase in the cost of goods and services, thereby causing inflation.
Commodity exposures in a portfolio can serve as a potential hedge against inflation. For example, during periods of inflation, the price of gold, a popular commodity, often increases. This increase can offset the decreasing purchasing power of money, providing a buffer against inflation.
Wage-push inflation is a specific type of cost-push inflation where the increase in wages is the primary factor driving up the cost of production. For instance, if a labor union successfully negotiates a significant wage increase, it can lead to an increase in the cost of goods and services, thereby causing inflation.
Inflation tends to exhibit momentum effects or event clustering. This means that periods of inflation are often followed by further periods of inflation. For example, if businesses, workers, and consumers expect inflation to continue, they may take actions that inadvertently perpetuate inflation, creating an inflationary momentum.
According to Arnott and Shakernia (2023), reverting to a 3% inflation rate is easy from 4%, hard from 6%, and very hard from 8% or more. This highlights the difficulty in controlling and reducing high levels of inflation once they have become established in an economy.
Inflation is a common economic phenomenon, with most markets experiencing a steady and controlled inflation rate. For instance, consumer prices in the United States have typically averaged between 2% and 2.5% growth per year. However, there are exceptions such as Japan, which has experienced extended deflationary periods with inflation averaging less than 0.5% per year.
Inflation in emerging markets like Brazil or India is often higher and more persistent than in developed markets. This can be attributed to several factors including the time required for fiscal and economic tools to take effect, political instability, and economic insecurity. These countries often deliberately devalue their own currency to stimulate economic growth by making their exports cheaper and encouraging local production.
Inflation risk is a significant concern for investors, particularly in the context of long-term investment goals such as retirement planning. It refers to the potential for a decrease in the purchasing power of money over time due to rising prices. While hyperinflation is an obvious risk, even low rates of inflation can lead to a substantial erosion of purchasing power over time due to the compounding effects.
To illustrate this, let’s consider US economy, which has experienced an average inflation rate of about 3% over the past century. Over a period of 40 years, a typical timeframe for retirement planning, this rate of inflation compounds to a cumulative increase in consumer prices of 226%. In practical terms, this means that investors can expect prices to more than double over their retirement planning horizon.
If the inflation rate were to increase to 4% over the same period, the impact on prices would be even more dramatic. In this scenario, prices would increase nearly four-fold, meaning that investors would only be able to purchase a quarter of what they could in the absence of inflation with the same nominal resources.
Despite recent trends in developed countries, inflation remains a substantial and immediate risk. It is therefore crucial for investors to factor inflation risk into their investment strategies and decisions.
The inflation rate, a key economic indicator, is typically gauged as the percentage change in a price index, primarily the Consumer Price Index (CPI). It’s crucial to understand that CPI varies across countries and multiple inflation rates exist. This is due to the differential impact of inflation on individuals and families, necessitating wealth managers to consider how inflation influences specific liabilities like education and healthcare costs on a family’s balance sheet.
As per Baumol and Bowen’s 1965 study, sectors with slow productivity growth such as education and healthcare witness faster inflation compared to high-productivity sectors like manufacturing. This trend is particularly noticeable in developed nations like the United States, where education and healthcare costs have consistently surpassed general consumer inflation for decades. Consequently, planning for healthcare in retirement and children’s education becomes critical.
Older citizens typically exhibit different spending patterns compared to younger citizens. To account for these variations, the US Bureau of Labor Statistics (BLS) publishes an index called CPI-E (Consumer Price Index for the Elderly), focusing on US citizens aged 62 years or older. While it measures the same categories as CPI-W (Consumer Price Index for Urban Wage Earners and Clerical Workers), it adjusts the weightings to better reflect the elderly’s spending. Notably, CPI-E almost doubles the weighting for healthcare costs (from 5.6% to 11%) and reduces the weight for education and transportation.
Over the past 40 years, CPI-E has risen more than CPI-W, largely due to the higher rate of healthcare cost inflation that significantly impacts the elderly. However, the US BLS labels CPI-E as an experimental index, cautioning its limitations, such as the fact it does not account for the specific geographies where the elderly live or the discounts they may receive.
Inflation rates vary across different lifestyle and income levels. For instance, a rise in fuel prices may significantly impact a low-income family who relies on public transportation, while a High Net Worth Individual (HNWI) who owns a luxury electric car may be unaffected. Similarly, luxury items like a Picasso painting or a Cartier watch often retain their value even during economic downturns, unlike common goods.
Forbes’ Cost of Living Extremely Well Index, introduced in 1976, tracks 40 luxury goods and services, including items like a Rolls-Royce or a stay at the Four Seasons. Over 34 years, this index has outpaced the US Consumer Price Index by an annual 2.4%, reaching a level 2.25 times higher.
The US Bureau of Labor Statistics (BLS) studies consumer price indexes across different income brackets to understand inflation’s varying impacts. Lower-income households often face higher inflation rates, while higher-income households can adjust their spending, such as opting for a home-cooked meal over a restaurant dinner, to counter inflation.
Assets like gold or real estate can serve as natural hedges against inflation. However, standard hedges tracking the Consumer Price Index (CPI) may not cover specific liabilities like college tuition or medical expenses, which usually inflate faster than general price levels.
Insurance policies with inflation-adjusted payouts, or prepaying tuition at universities that offer such programs, can serve as hedges against inflation in specific categories.
Inflation risk can be managed by selecting investments that hedge against inflation. For instance, investing in Treasury Inflation-Protected Securities (TIPS) can provide a hedge against inflation. The exposure to inflation risk can be quantified in nominal units of currency. The optimal amount of hedging against inflation can be calculated as the product of the nominal exposure and the minimum variance inflation hedge ratio.
Inflation factor, \(\beta\) of an investment relates the return or nominal growth of an investment goal in a given period \(R_{Goal,t}\), the inflation in that period \(\pi\), and an error term \(\eta\). This relationship can be expressed as:
$$R_{Goal,t} = \alpha_0 + \beta_{Inf,Goal}\pi_t + \eta_t$$
The nominal return or growth of an investment goal, such as the present value of retirement income, is difficult to observe directly. Unlike inflation, which can be observed through market prices, the nominal return is based on a subjective discounted cash flow analysis. However, it is possible to assess its sensitivity to inflation heuristically.
The investment goal’s inflation factor beta, denoted as \(\beta\), can be broken down into two components: \(\rho\), the correlation coefficient between the investment goal’s return and inflation, and the relative volatilities \(\sigma_{\text{Goal}}\) and \(\sigma_{\text{Inf}}\) of the investment goal and inflation, respectively. The inflation factor beta is:
$$\beta_{\text{inf,Goal}} = \rho \frac{\sigma_{\text{Goal}}}{\sigma_{\text{Inf}}}$$
The effectiveness of inflation hedging increases when the correlation between the investment goal and inflation rises, the relative volatility of the investment goal increases, and the strength of the relationship between the investment goal and inflation, as indicated by the R-squared value of the regression, intensifies.
The need for inflation hedging becomes more significant with an increase in the investor’s risk aversion and the extension of the investment time horizon. For instance, individuals who have used up a larger portion of their human capital should prioritize long-term strategies that protect against inflation. For High Net Worth Individuals (HNWI) and Ultra High Net Worth Individuals (UHNWI), the impact of inflation may be less significant. However, completely hedging their entire portfolio against inflation is often not feasible. A more practical approach for them is to hedge only the portion of their wealth that aligns with their anticipated lifetime expenses.
The inflation beta of a potential hedge asset can be calculated using:
$$R_{\text{Hedge},t} = \alpha_0 + \beta_{\text{Inf,Hedge}}\pi_t + \eta_t$$
where \(R_{\text{Hedge},t}\) is the return on the hedge asset in period t, \(\alpha\) is the intercept of the regression, \(\beta\) is the slope of the regression (inflation beta), \(\pi\) is the inflation rate, and \(\eta\) is the error term.
The inflation hedge ratio, which represents the relative notional amount of exposure to take in a hedged asset to offset the pre-existing exposure, can be calculated as:
$$H_{\text{Inf}} = \left( \frac{\beta_{\text{target}} – \beta_{\text{Inf,Goal}}}{\beta_{\text{Inf,Hedge}}} \right) \left( \frac{\text{Goal}}{\text{Hedge}} \right)$$
where H is the inflation hedge ratio, \(\beta_{\text{Target}}\) is the desired amount of inflation exposure, \(\beta_{\text{Inf,Goal}}\) is the inflation beta of the investment goal, and \(\beta_{\text{Inf,Hedge}}\) is the inflation beta of the hedging asset.
In the special case where the goal is to eliminate inflation risk, the equation reduces to:
$$H_{\text{Inf}} = \left( \frac{\beta_{\text{Inf,Goal}}}{\beta_{\text{Inf,Hedge}}} \right) \left( \frac{\text{Goal}}{\text{Hedge}} \right)$$
Inflation-Linked Fixed Income revolves around the idea that an asset’s real return, the nominal return minus inflation, should remain relatively stable over time and across different inflation regimes. However, this is not always the case with fixed income, as its real returns can vary significantly across different inflation rate environments, especially in high inflation environments.
Several fixed income instruments adjust their coupon payments based on the inflation rate, making them potential candidates for inflation hedging. For instance, the United Kingdom has inflation-linked gilts, Europe has European Inflation-Linked Bonds (ILBs), and the United States has Treasury Inflation Protected Securities (TIPS). In countries like Chile, there are even inflation-linked corporate bonds.
Despite these features, the correlation between inflation and the returns of 20-year constant maturity, coupon-bearing, inflation-linked bonds is -0.41. This negative correlation makes them a surprisingly poor hedge against inflation historically. Although this negative correlation is only half as large as that for conventional bonds with coupons that are not indexed to inflation, these bonds are still exposed to price risk resulting from interest rate fluctuations.
Inflation-Linked Annuities are a specialized form of fixed income investment designed to manage longevity risk. They are similar to national retirement programs like the United States’ Social Security or Canada’s Old Age Security, which adjust benefits annually based on wage rate or Consumer Price Index (CPI) increases, effectively making them akin to inflation-adjusted annuities.
Investors often seek ways to actively control inflation, which can be challenging due to the high negative correlation with inflation across many asset classes. However, a potential strategy to hedge against inflation is through borrowing. This involves taking short positions in assets that are highly negatively correlated with inflation, such as fixed income. Essentially, investors borrow money that is paid back in less valuable currency units during inflationary periods, providing a form of insulation against rising prices.
While borrowing can be an effective strategy against inflation, it’s important to consider the following:
It’s crucial to note that hedging against inflation is complex and can introduce risks that need to be hedged separately. However, informed and strategic choices can offer a degree of protection.
For instance, a wealth manager might suggest using the proceeds of a short sale to purchase Treasury Inflation-Protected Securities (TIPS), variable rate debt, an inflation-linked annuity, or perhaps some other one of the lower volatility assets.
Equity is often perceived as a potent shield against inflation. However, historical data spanning from 1900 to 2022 reveals a negative correlation of -0.25 between real equity returns and inflation. This suggests that during times of high inflation, real returns on equity tend to be poor. It’s essential to distinguish between surpassing inflation and hedging against inflation.
Companies capable of transferring increased costs to consumers, especially those offering essential goods or services with strong brand loyalty and limited competition, typically fare better during inflation. For instance, investing in companies like Apple or Amazon can help preserve investment value and generate consistent earnings. Stocks in sectors like Exxon Mobil in energy or BHP in resource mining can also perform well during inflation.
Direct investment in commodities like gold or oil is considered a more direct hedge against inflation. This topic will be explored in greater depth later.
In an inflationary economy, equities like those of companies in the S&P 500 tend to perform better when economic activity is high. However, irrespective of the level of economic growth, equity returns remain negatively correlated with inflation.
Investments in commodities, such as gold, oil, or wheat, can be made either directly through purchasing the physical commodities in spot markets or indirectly via commodity derivatives market. These commodities, whether physical or financial, have varying inflation hedging characteristics. For instance, gold is often viewed as a natural hedge against inflation.
Spot markets are platforms where commodities are bought and sold for immediate delivery. Changes in commodity prices can be seen as a reflection of inflation since they represent the price of goods in the marketplace. However, these commodities are often inputs in the production process, and their price changes may not necessarily translate to consumer price indexes.
An equally weighted portfolio of spot commodities has a modest positive correlation of +0.10 with inflation, indicating a slight tendency to move in the same direction. Despite the positive correlation and real returns, the high annual volatility of real return makes it a poor inflation hedge. The annual volatility of an average spot commodity is 27.55%, similar to equity market returns, which reduces the geometric mean excess return to -0.93%. However, when these assets are combined into an equally weighted portfolio, the annual volatility decreases to 12.47%, enhancing the geometric return to 1.58%.
Commodity futures represent a viable investment strategy that investors can leverage to hedge against inflation. Despite the global market for commodity futures being less liquid than the fixed income and equity markets, they provide a systematic approach to invest in commodities without the need for physical trading or storage, which can be both expensive and impractical.
An equally weighted portfolio of commodities futures has a correlation of +0.21 with inflation. This correlation is greater than that for spot commodities, but still fairly modest. However, commodity futures are relatively uncorrelated with the returns on equity and fixed income, making them potent diversifiers in a comprehensive portfolio. The geometric mean return of an equally weighted futures portfolio is also significantly higher than that of an equally weighted spot commodity portfolio.
While the annual correlation of commodity futures with inflation is positive but somewhat modest, research by Gorton and Rouwenhorst (2006) found that the correlation increases to +0.45 for a five-year holding period. This suggests that commodity futures may be a better inflation hedge in the long-term than in the short-term. However, maintaining a consistent long-term exposure in the commodity futures market may not always be practicable.
According to Ilmanen (2022), commodity futures also enable wealth managers to hedge against different types of inflation. Cost-push inflation, which is caused by a rise in energy prices, can be hedged with energy futures. Demand-pull inflation can be effectively hedged with commodity futures on industrial metals. Inflation caused by excessive central bank monetary easing and/or banking crises may be best hedged with precious metals, especially gold.
Gold, a precious metal with a unique cultural significance, is often perceived as a stable store of value and a safeguard against economic disasters. It is particularly seen as a countermeasure to the risks associated with fiat currencies. For instance, from 1972 to 2022, gold demonstrated the highest correlation with inflation, a period following the decoupling of currencies from gold. However, the overall correlation of gold prices with inflation from 1900 to 2022 is negative, at -0.04, indicating that gold may not be an effective long-term hedge against inflation.
Despite the negative correlation, the price of gold has generally risen as price levels have increased. However, the gold price exhibits significant fluctuations around the Consumer Price Index (CPI), suggesting that it may not be an effective short-term hedge for inflation. For instance, the real price of gold from 1975 to 2012 shows significant year-over-year variability, with a triple increase in the first five years, an 80% fall over the next 20 years, and a five-fold increase over the following 10 years.
When analyzing the rolling 10-year real and nominal returns to gold with the rolling 10-year inflation rate, it is evident that the trailing 10-year real gold return was negative from 1985 to 2005. This further supports the argument that gold was not an effective long-term inflation hedge during this period.
Real estate investments, a crucial part of an investment portfolio, can be categorized into two main types: Residential and Commercial. For instance, a residential investment could be a single-family home in New York, while a commercial investment could be a shopping mall in Los Angeles.
Commercial real estate is a diverse category with several subcategories, including multifamily dwellings, industrial buildings, offices, logistics and last mile infill, hospitality and hotels, retail, and other categories like self-storage, theme parks, car washes, bowling alleys, boating marinas, movie theaters, funeral homes, community centers, and nursing homes. These categories are dynamic and evolve over time. For example, logistics and last mile infill have emerged as significant categories in the 21st century.
Contrary to popular belief, real estate is not always an effective inflation hedge. The annual correlations between inflation and the returns of these various real estate categories are generally negative. This is because while housing prices may increase in inflationary environments, rental rates and lease agreements are often fixed in the short term. However, they can keep pace with inflation over the longer term. Similar to Treasury Inflation-Protected Securities (TIPS), the capital component of total return also needs to be considered, which is usually negatively affected by the higher interest rates that tend to accompany inflation.
The effects of inflation and taxes on investment returns is crucial for any investor. Taxes are typically calculated based on nominal income and returns, not real income and returns. This implies that the tax basis for capital gains tax is usually not adjusted for inflation, except in rare cases. Consequently, when inflation is high and nominal returns increase to compensate investors for expected inflation, the investor’s tax liability also increases, even if pretax real returns remain the same.
The after-tax future value interest factor of investments taxed as capital gains (FVIFcgb) is calculated as:
$$FVIF_{cgb} = (1 + r)^n(1 – t_{cg}) + t_{cg}B$$
where:
r = rate of return
n = number of periods
t = tax rate on capital gains
Bcg = cost basis expressed as a proportion of the current market value of the investment
The interaction between taxes and inflation is multiplicative. This means that if either taxes or inflation is low, the effect on the investment is modest. For example, if the inflation rate is 1% and the tax rate is 10%, the after-tax value of your investment would be $90,000, which is still higher than your initial investment. However, when inflation is high, the capital gains tax structure of equities reduces their relative attractiveness.
For wealth managers and their clients, there is no single investment tool that effectively hedges against inflation. However, a combination of tools, including both tradable and non-tradable assets, can offer partial or blunt protection from the effects of inflation. For example, investing in a mix of stocks, bonds, and commodities can provide a diversified portfolio that can withstand different economic environments.
Stocks and bonds have been poor inflation hedges even if their returns tend to exceed inflation. This is a global phenomenon. Returns to commodity futures, on the other hand, have a modest positive correlation with inflation, making them a potential hedge for inflation. However, this is based mainly on US data. Additionally, commodities’ negative correlations with stock and bond returns tend to increase with the holding period, making them both a potential diversifier as well.
The correlation coefficient measures the degree to which two variables move in relation to each other. A positive correlation indicates that the variables move in the same direction, while a negative correlation indicates that they move in opposite directions.
Practice Questions
Question 1: An investor is considering adding commodity exposures to their portfolio as a potential hedge. They are particularly concerned about the impact of inflation on their investments. How might commodity exposures serve to protect the investor’s portfolio against inflation?
- Commodity exposures can decrease in value during periods of inflation, thereby providing a buffer against the increasing cost of goods and services.
- Commodity exposures can increase in value during periods of inflation, thereby providing a buffer against the decreasing purchasing power of money.
- Commodity exposures can remain stable in value during periods of inflation, thereby providing a buffer against the fluctuating cost of goods and services.
Answer: Choice B is correct.
Commodity exposures can increase in value during periods of inflation, thereby providing a buffer against the decreasing purchasing power of money. Inflation is characterized by a general increase in prices and fall in the purchasing value of money. When inflation occurs, the cost of goods and services increases. Commodities, being raw materials, are the basic building blocks of many of these goods and services. Therefore, when the cost of goods and services increases due to inflation, the value of commodities often increases as well. This is because the increased cost of goods and services often translates into increased demand for the commodities used to produce them. As a result, commodity prices can rise during periods of inflation. By investing in commodities, an investor can potentially benefit from these price increases, thereby offsetting the negative impact of inflation on the purchasing power of their money. This is why commodities are often considered a good hedge against inflation.
Choice A is incorrect. Commodity exposures do not typically decrease in value during periods of inflation. As explained above, commodity prices often increase during periods of inflation due to increased demand for the commodities used to produce goods and services. Therefore, investing in commodities would not provide a buffer against the increasing cost of goods and services by decreasing in value.
Choice C is incorrect. Commodity exposures do not typically remain stable in value during periods of inflation. Commodity prices are influenced by a variety of factors, including supply and demand dynamics, geopolitical events, and economic conditions, among others. Therefore, it is unlikely that commodity prices would remain stable during periods of inflation, when the cost of goods and services is increasing.
Question 2: A country is currently experiencing an inflation rate of 9%. According to the research by Arnott and Shakernia, what can be inferred about the country’s potential timeline to revert to a 3% inflation rate?
- The country can revert to a 3% inflation rate within 1 to 5 years.
- The country can revert to a 3% inflation rate within 6 to 20 years.
- The country can revert to a 3% inflation rate within 21 to 35 years.
Answer: Choice B is correct.
According to the research by Arnott and Shakernia, a country experiencing an inflation rate of 9% can be expected to revert to a 3% inflation rate within 6 to 20 years. This research suggests that the process of inflation reversion is not immediate and can take a considerable amount of time. The timeline for reversion is influenced by a variety of factors, including the country’s economic policies, its level of economic development, and external factors such as global economic conditions. The research by Arnott and Shakernia provides a general guideline for the expected timeline for inflation reversion, but the actual timeline can vary significantly depending on the specific circumstances of the country. It is important for investors and policymakers to understand this timeline in order to make informed decisions about economic policy and investment strategies.
Choice A is incorrect. According to the research by Arnott and Shakernia, a country experiencing an inflation rate of 9% is unlikely to revert to a 3% inflation rate within 1 to 5 years. This timeline is too short for the process of inflation reversion, which is influenced by a variety of factors and can take a considerable amount of time.
Choice C is incorrect. According to the research by Arnott and Shakernia, a country experiencing an inflation rate of 9% is not expected to take 21 to 35 years to revert to a 3% inflation rate. While the process of inflation reversion can take a considerable amount of time, this timeline is longer than the typical timeline suggested by the research.
Private Wealth Pathway Volume 2: Learning Module 5: Preserving the Wealth;
LOS 5(c): Recommend planning and investment strategies to mitigate the corrosive influence of inflation on preserving purchasing power