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Inflation And Inflation Hedges
By Francis Gupta | 01 September, 2011   

Real returns from different asset classes for investors in the euro area and the US.

Inflation And Inflation Hedges

Inflation is an increase in the price of goods and services as experienced by all consumers. Because inflation decreases the purchasing power of money, its direct impact can be measured as a reduction in the real return on investments. The real return on an investment differs from the nominal return in that the real return factors in the decline in the value due to inflation—the nominal return does not. So if inflation is high enough, an investment with stellar nominal returns could result in real returns that are marginal or even negative. The good news is that, compared to historical inflation rates, in recent years inflation rates for both the US and Europe have been relatively low (annual averages in the 2% to 3% range) so as to have a muted impact on real returns. But the bad news is that the nominal returns on many assets (for instance equities) in recent years have also been negligible.

Even though inflation has been less of a threat more recently than in the past, most investors are still acutely aware of the damaging effect that high levels of inflation can have on the purchasing power of their portfolios, especially in the long run. Consequently, investors are constantly on the search for investments and investment strategies that can provide a hedge against the inflation risk inherent in their portfolios. Investable assets, such as commodities, the intrinsic values of which increase with inflation, are generally considered a good inflation hedge and are referred to as real assets. This article analyses the performance of a traditional set of real assets to understand if they have indeed provided a hedge against inflation for the US and for the euro area. In addition, we also present a dynamic real asset and test its inflation hedging capabilities in the US and the euro area.

The major finding from our analysis is that even though the euro area and the US look very similar in terms of inflation and asset class performance, assets that are traditionally considered as inflation hedges might not provide the same inflation hedging benefits in the euro area as they do in the US. In other words, inflation as a risk factor has a different impact on assets within the US and Eurozone and therefore real assets which provide a hedge against inflation for the euro area might be different from those that do so for the US.

So, how did inflation compare historically in the US and Europe? Figure 1 presents the 12-month rolling inflation for the Consumer Price Index for all urban consumers (US inflation) and for the Harmonised Indices of Consumer Prices for the euro area and the European Union (inflation for the euro area and European Union, respectively).

Inflation: 12-Month Rolling—US, European Union And Euro Area

For a larger view, please click on the image above.

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