Annual inflation exceeded 4% in the United States in April, this is the largest increase in more than a decade. Unfortunately, if held up, rising inflation is often not good for investors. The classic 60/40 stock / bond portfolio can be hit from both sides, as prices go up, stocks and bonds can go down. In fact, a 60/40 strategy has historically yielded around 9% per year, but closer to 2% in times of high inflation. Plus, stocks aren’t particularly cheap before you even factor in potential inflation.
Of course, once the strategy is to stick with your wallet. Periods of inflation are not that common. Basically we have seen 1 in 5 years of high inflation looking back over decades. Strategies that work well in times of inflation often perform poorly in other economic outcomes. As such, there is a risk of adapting to something that is either temporary or not going as planned.
What works during inflation
Again researchers from the Man Group and Duke University calculated the numbers that investment strategies have historically held up to, and that’s what they found.
Basically, commodities have historically been a good bet during times of inflation. This makes sense, because in order for prices to rise, it is highly likely that the prices of the commodities that power the various goods and services in the economy will also rise. This is what is observed. Whether it’s energy, metals, agricultural products or other raw materials, most tend to increase during times of high inflation.
Now betting on any commodity can be risky, for example gold has risen about two-thirds of the time in historically inflationary environments. However, if you have a large basket of different products, then historically you have taken the advantage. In fact, collectibles like art, wine, and stamps can work well in inflationary environments. Again, owning a diversified basket can be more reliable than betting on a single asset.
Now there is no free lunch. The risk is above all that this inflationary episode will not continue. If we don’t see a spike in inflation, then commodities are generally performing poorly. Most commodity returns have historically occurred during inflation. During non-inflationary times, many commodities may even lose value on average based on history. This is not a setup for the success of the investment.
There is also the potential risk of arriving too late. Some products have already skyrocketed, so it’s unclear what the price is already embedded at current levels for specific assets. For example, an ETF that closely tracks the Goldman Sachs Commodity Index is already up 25% for the year so far at the time of writing. Further increases are of course possible, but it is clear that part of the rally in commodities has already occurred.
What other strategies work during times of inflation? Unsurprisingly, trend following may be among the best. It is essentially a question of holding assets whose price has increased in absolute or relative terms in recent months.
It works particularly well with commodities during times of inflation, but has also improved the yields of bonds, currency pairs, and stocks. It should also be noted that many factors that can generally work well in most market environments, on average, can lag during times of higher inflation. This includes focusing on factors like value, size, low volatility. Among factor strategies, dynamic investing stands out. It has historically worked during high inflation, but more importantly has also generated returns when inflation is not present.
At the sector level, unfortunately there is often nowhere to hide with high inflation. You might assume that with rising energy prices, energy stocks could perform well. Unfortunately no. Energy can outperform other sectors during episodes of inflation, but the returns are still uninspiring if history is to be trusted. The main way to spot winning stocks during times of inflation, at least at the factor level, appears to be momentum. Stocks that have already risen may tend to continue to rise, at least in the short term.
The big question
This historical research is instructive, but highlights the main challenge. In an inflationary environment, choosing a less traditional investment strategy, such as a greater focus on commodities, can improve returns.
Additionally, many proven strategies, like a classic 60/40 portfolio, can lag behind in high inflation. If inflation continues, considering a greater tilt towards commodities and moving away from stocks and bonds may be prudent.
Yet the fundamental question remains as to what the recent price spike means. Is normalcy starting to pick up after the pandemic, as supply chains resolve their issues after a disruption? Or is what we’re seeing now, the start of more persistent inflation that’s harder to beat? History tells us how to invest in times of inflation, but two questions remain as to, on the one hand, how long does this inflation last and, on the other hand, how far the inflation rate rises. , otherwise is not the peak.