With rising inflation in recent months, stock market investors have been using long-held street wisdom to find hedges, or protection, in commodities, REITs or real estate investment trusts, as well as stocks and equity mutual funds. But while those asset classes provide hedges against energy inflation, they do not offer protection against core inflation, according to a new research paper by experts at Wharton and the University of Hong Kong titled “Getting to the Core: Inflation Risks Within and Across Asset Classes.”

“The key takeaway from our research is that you have to look at what is known as core inflation separately, excluding food and energy items,” said Wharton finance professor Nikolai Roussanov, who co-authored the paper with Xiang Fang and Yang Liu, both assistant professors of finance at the University of Hong Kong. “A lot of the discussion in the popular press on different asset classes in their relation to inflation tend to miss this distinction.”

Core inflation tracks prices of goods and services including shelter, household furnishings and operations, apparel, transportation, medical care and recreation. The indexes for core inflation, along with those for food and energy inflation, make up the consumer price index, or headline inflation. The consumer price index for urban consumers in June 2021 rose 5.4% (before seasonal adjustments), representing the largest 12-month increase in 13 years, according to the latest labor department report. Within that, core inflation rose 4.5%, the largest 12-month increase since November 1991, and energy inflation rose 24.5%; the food index rose 2.4%.

“[Conventional wisdom that] commodity futures, for example, are good protection against inflation because commodity prices will go up is not necessarily true,” said Roussanov. Commodity futures do provide a hedge against energy inflation, “but energy is not always the important component of inflation,” he added. “It just so happened that in the last 20 years, inflation has been subdued overall and energy being its most volatile part really kind of stood out. A lot of movement of inflation has been obscured by high energy prices, oil in particular being the most powerful.”

“A lot of movement of inflation has been obscured by high energy prices, oil in particular being the most powerful.” –Nikolai Roussanov

Key Findings

“We argue that decomposing inflation into core and non-core components (with a particular focus on energy) is important as it sheds new light on the nature of inflation risks,” the paper’s authors stated. “First, core and energy inflation have sharply different statistical and economic properties. Second, inflation-hedging properties of conventional ‘real assets,’ such as stocks, currencies, and commodity futures, are largely confined to energy inflation, while they provide almost no protection against core inflation risk. Third, core inflation carries a significantly negative price of risk, while the risk price associated with energy inflation is in most cases indistinguishable from zero.”

In their study, the authors examined returns in seven major asset classes between 1963 and 2019: U.S. stocks, Treasury notes/bonds, agency bonds, corporate bonds, currencies, commodity futures, and REITs. The data had varying starting points between 1963 (for stocks and treasuries) and 1983 (for energy).

These were their key findings:

  • The conventional wisdom that stocks, currencies and commodity futures are real assets is incomplete: They only hedge against energy inflation. A long position in none of these seven asset classes can hedge against the core inflation.
  • The cost of hedging against inflation – or the price of these inflation risks – of headline and energy inflation are indistinguishable from zero. However, core inflation carries a sizable negative price of risk. In other words, insuring your portfolio against core inflation is potentially costly due to foregone returns.
  • Among commodities, precious metals, especially gold, are the most well-accepted assets to preserve value. Gold and platinum have positive core inflation betas (volatility and therefore risk) that are statistically indistinguishable from zero and they strongly hedge against energy inflation. These precious metal futures have relatively low returns and high volatility, so their ability to protect against core inflation risk is far from assured.

New Paradigms

Inflation dynamics have also changed in the aftermath of the pandemic. “Post-Covid, core inflation or prices of goods have been going up across wide swathes of the economy, not just energy costs,” Roussanov said. Higher prices of commodities push up costs elsewhere in the economy, too, he added. “Those two components of inflation – core inflation and energy inflation – often do not go in tandem. But when they do and they both rise, they’re going to in some sense reinforce each other.”

Apart from commodities, most other asset classes too “don’t provide good protection” against core inflation, he added. Markets across the board are revising assumptions about assets that were hitherto considered decent hedges against inflation — cryptocurrencies like bitcoin, gold and other precious metals, and treasury inflation-protected securities, or TIPS, whose values are adjusted for changes in the consumer price index. Bitcoin prices, for instance, have been falling steadily from their March 2021 peak.

“Now, we might actually see that both stocks and bonds will go in the same direction, which, of course, magnifies the risk for an investor’s portfolio.” –Nikolai Roussanov

The relationship between stocks and bonds is also set to change, according to Roussanov. “Over the last 20 years, [a combination of stocks and bonds] has proved a very robust portfolio because in good times, stocks outperform and bonds are more or less safe,” he said. “And in bad times, the Fed cuts interest rates so bond yields go down, which is good for bond prices. So even though stocks fall, say in the Great Recession or even in March 2020 with Covid, the prices of Treasury bonds actually shot up because of the cuts by the Fed, which compensated investors with these types of portfolios to a certain extent.”

“We might see a break in this negative relationship between bonds and stocks,” Roussanov continued. “When we have a pickup in inflation, it will be bad for stocks, and it will be bad for bonds at the same time.” That new equation played out around February 2021, “when there was this increasing worry about inflation, with bond yields going up and stock prices starting to sputter as well,” he noted. “This is the paradigm that we should potentially get accustomed to. Now, we might actually see that both stocks and bonds will go in the same direction, which, of course, magnifies the risk for an investor’s portfolio.”

Options for Investors

What then are the dependable inflation-hedging options in the current scenario for investors? “Sit tight. There will be very few things in that basket as far as we have been able to find so far,” said Roussanov. “Some of the precious metals such as gold and platinum do seem to have some inflation-hedging potential. But they are not very reliable or very strong in the sense that those are pretty volatile.” He noted that while bitcoin or other cryptocurrencies are seen by some market watchers as an option, he and his coauthors refrain from recommending them because their relative nascency doesn’t offer sufficient historical data to make any inferences; he also pointed to their recent price volatility as a negative.

TIPS, however, are always an option for investors, according to Roussanov, “TIPS offer a reliable [option] for those who want to protect their portfolios against inflation; TIPS are the safe haven. They’re not particularly attractive – they have negative yields precisely because inflation expectations have increased.”

“If [the current trend] in inflation is transitory and fairly mild, a well-balanced portfolio that has a number of stocks and inflation-protected bonds should do reasonably well in the near to medium-term future.” –Nikolai Roussanov

Demand for TIPS has been surging, and they drew a record $36.3 billion in new investments in the first half of 2021, another Wall Street Journal report said, citing data from Morningstar. After inflation adjustments, TIPS rates have trended at below 1% for most of the past decade and gone negative in recent years, with the tradeoff being the protection against inflation for the principal amount.

Of course, continued high inflation is not necessarily set in stone, and much depends on how the Fed responds to the recent spikes. Federal Reserve Chairman Jerome Powell said last week in a House testimony that recent inflation was uncomfortably above the levels the central bank seeks, the Wall Street Journal reported. In June, Powell had noted that he expected inflationary pressures to be transitory because many goods and services have seen one-time price increases after the reopening of the economy, such as air travel and hotel rates, or new and used cars.

“We will have to wait and see whether the view of the Fed is right that this pickup in inflation is truly transitory, and we’ll get back to where we were a couple of years ago,” said Roussanov. “It is certainly not a foregone conclusion that we are going to see a continued pickup in inflation. I would not expect anything close to what people worry about — the nightmare scenario of the 1970s with great inflation. I don’t see the conditions for that.”

That outlook offers hope for investors. “If [the current trend] in inflation is transitory and fairly mild, a well-balanced portfolio that has a well-balanced combination of stocks and inflation-protected bonds should do reasonably well in the near to medium-term future,” said Roussanov.