Which Asset Classes Provide Inflation Hedges?

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Nominal fixed-income securities such as bonds do not protect investors against unexpected inflation. In addition to inflation eroding the purchasing power of payouts, bond prices also fall when interest rates rise, which typically occurs during inflationary periods. In contrast, investors often consider real assets like stocks, real estate, and commodities to be effective inflation hedges. Real estate and commodity prices, which enter the price level directly or indirectly, should track inflation to some degree. Stocks are claims to real cash flows, which should keep pace with inflation if firms can pass higher input costs forward to consumers.

In Getting to the Core: Inflation Risks within and across Asset Classes (NBER Working Paper 30169), Xiang Fang, Yang Liu, and Nikolai Roussanov find that while real estate, commodities, and stocks provide protection against energy inflation, they do not hedge against core inflation, which excludes energy and food prices, and is substantially less volatile but much more persistent than food and energy inflation.

Real assets such as stocks, real estate, and commodities offer a better hedge against energy price increases than against core, or headline, inflation.

The researchers analyze average returns across eight major asset classes over the period 1963 to 2019. They consider Treasury, corporate, and agency bonds, domestic and international stocks, real estate investment trusts (REITs), commodity futures, and currencies. For each asset class, they calculate the return associated with a one standard deviation increase in unexpected headline, core, or energy inflation.

A one standard deviation increase in headline inflation is associated with a −3.1 percent return to US common stocks, on average. Stocks decline by 8.1 percent, however, when core inflation increases by one standard deviation after accounting for unexpected energy inflation, which is associated with positive stock returns. Treasury, corporate, and agency bonds display negative returns in response to all three types of inflation. While REITs, currencies, and commodities all offer a hedge against energy inflation, commodities fare best against a rise in core inflation.

In light of the comovement pattern of asset returns and the various components of unexpected inflation, the researchers conclude that the cost of hedging against headline and energy inflation is about zero. However, investors demand compensation, in the form of expected excess returns, of about 1 percent per year for holding an asset with one additional unit of negative exposure, or “beta,” to core inflation. The estimated expected excess return for bearing core inflation risk is consistent within and across asset classes.

An increase in headline inflation is associated with reduced GDP, consumption, and dividend payments in the next quarter. This effect is driven entirely by core, rather than energy, inflation. For stocks, core inflation is associated with reduced firm cash flows as well as an increase in discount rates. Both factors negatively affect stock prices.

The researchers conclude by noting that before 1999, an increase in headline inflation was associated with negative returns on both stocks and Treasury bonds. However, after 1999, the negative effect on bond returns remains, but the effect of headline inflation on stocks becomes positive, largely as a result of energy inflation becoming positively correlated with stock returns in the later period.

— Aaron Metheny