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Inflation And Inflation Hedges
Written by Francis Gupta   
September 01, 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.

Inflation
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.

The following observations emerge for the time period under consideration (i.e. January 1997 to May 2011): first, inflation was relatively low for all the regions, so much so as to be not taken seriously. The average annual inflation rates were around 2% for the euro area (and the European Union) and about 2.5% for the US.

Second, inflation volatility was also relatively low for all of the regions, making inflation even less of a threat. However, even though the volatility of monthly inflation rates was insignificant, the ranges for the 12-month rolling inflation were not insignificant. For the euro area, the 12-month rolling inflation reached a high of 4.0% (in June and July of 2008) and a low of -0.6% (in July of 2009) for a total spread of 4.6%. For the US the 12-month rolling inflation reached a high of 5.6% (in July of 2008) and a low of -2.1% (in July of 2009) for a total spread of 7.7%. Even though monthly and annual inflation rates are relatively low, the rolling 12-month inflation rates can vary significantly.

Third, and not least, is the observation that inflation rates for Europe and the US are highly correlated. The contemporaneous monthly inflation rates between the euro area and the US exhibit a correlation of 38%, while the 12-month rolling inflation rates exhibit a correlation of 78%. It may be tempting to conclude that this observation is as a result of global contagion and/or is an outcome of similar inflation-inhibiting economic policies amongst the developed countries/regions, but the inflation data for Japan (presented in Appendix A) suggests that this conclusion would require more research to be validated.

Annual Inflation Rates: 1997 to 2010

Inflation Hedges
The statistical correlation between euro area inflation and US inflation suggests that asset classes that have historically worked as inflation hedges in the US might also provide similar protection against inflation in the euro area. Figure 2 presents the asset classes conventionally thought of as hedges against inflation. It also includes the indices that will be used in this article to measure those asset classes, and the names they will be referred to going forward.

The asset classes analysed in this article for their performance and hedging capabilities include inflation indexed bonds, broad equities, real estate, commodities and a composite real asset that alters its composition to inflation indexed bonds, real estate and commodities according to those that are exhibiting the largest correlation with inflation at a point in time. (Presumably because the impact of inflation on the various asset classes differs over time, a single real asset is not capable of providing an adequate hedge against inflation). These asset classes are analysed both for the US and the euro area and the results are compared.

Asset Classes And Measures

Performance And Correlations
Figure 3 presents the nominal and real performance of the asset classes for consideration as inflation hedges. We have already alluded to the fact that over the time period under consideration, inflation for the euro area was very similar to that of the US, or vice versa. But what is even more striking is that the performance of the other asset classes is also very similar (and identical for commodities since the local currency risk is assumed to be hedged).

In the 21st century so far, inflation has been low compared to in the 20th century. But even then, adjusting for the change in the purchasing power in the US, one 2000 US dollar was worth less than 75 cents at the end of May 2011. In the euro area, one euro in 2000 was worth less than 79 euro cents at the end of this period. That is a decline in value of more than 25% in the US and 21% in the euro area in less than 12 years.

In the current century to date, the top performers have been real estate and commodities, generating returns slightly above those in the previous century. Within commodities, precious metals were the top performers, followed by industrial metals. Energy was noisy (with the highest volatility) and managed to generate a slightly positive real annual return. Equities have been a disappointment so far; for both the US and euro area, real returns on equities have been negative in spite of the fact that inflation was so low. On the upside, the returns for both TIPS and GILB have been respectable (especially when measured on a return/risk basis) indicating that investors’ inflation expectations differed dramatically from realised inflation (in other words, investors clamoured to these bonds, not wanting to be caught unprotected if inflation were to spike, therefore hiking the price).

Performance—Nominal And Real (January 2000 to May 2011)

A good inflation hedge is supposed to outperform inflation and at the same time be correlated with inflation. In other words, the returns of the inflation hedge co-vary with inflation but have a higher average. To illustrate the co-movement of these asset classes with inflation, Figure 4 presents the asset class correlations for the US and euro area.

Besides the fact that the correlations of the asset classes with inflation are very similar for both regions, the key observation to emerge is that none of the asset classes are highly correlated with inflation. Within the US, commodities provided the best inflation hedge primarily because of the high correlation of energy and precious metals. TIPS provided a weak inflation hedge with the US. The euro area was another story: euro-hedged commodities provided the best inflation hedge more as a result of the correlation between energy and euro area inflation and less as a result of the correlation with precious metals. Euro area GILB were slightly negatively correlated to euro area inflation.

Asset Class Measures—Correlations Of Nominal Monthly Returns (January 2000 to May 2011)

A Real Asset Inflation Hedge
In the previous section we presented the correlations of the asset classes with inflation over the entire 21st century, ending May 2011. But when the correlations are analysed over a shorter period (say rolling 36 months), the picture that emerges is dramatically different from that given by a single snapshot. The shorter period correlations change significantly with time, indicating that different assets are correlated differently with inflation during different points in time (see Appendix B).

36 Month Rolling Correlation Against Euro Area Ination (HICP) 1/2000 - 5/2011

36 Month Rolling Correlation against US Ination (CPI-U) 1/2000 - 5/2011

Using this observation of correlation, this section presents the performance of a dynamic real asset over this time period. This real asset is “dynamic” because at any point in time it is composed of the three real assets that are exhibiting the highest correlation with inflation. In comparison, the “static” real asset invests in all of the real assets irrespective of their correlations at the point in time.

Figure 5 presents the results of our search. For both the US and euro area, the static versions of the DJ Real Asset Indexes outperform the dynamic versions.

For the US, holding all of the real assets results in a real annual return of 7.9% (nominal annual return of 10.8%) with a volatility of 13.3%, which is much lower than that of equities. Shifting the investment strategy to hold the three assets most correlated with US inflation at a point in time drops the real annual return to 5.5% (nominal annual return to 8.3%) and increases the volatility to 17.6%, which is more equity-like. This lower return and higher volatility buys the investor a strategy that is correlated slightly more with inflation (24% versus 21%).

For the euro area, holding all of the real assets results in a real annual return of 7.8% (nominal annual return of 10.1%) with a volatility of 13.0%, which is much lower than that of equities.

Shifting the investment strategy to hold the three assets most correlated with euro area inflation at a point in time drops the real annual return to 3.6% (nominal annual return to 5.8%) and increases the volatility to 17.2%, which is more equity-like. This lower return and higher volatility buys the investor a strategy that is correlated slightly more with inflation (12% versus 9%).

The correlations of the DJ Real Asset Indexes indicate that the composite real asset investment strategy is more successful at building an inflation hedge for the US than for the euro area. This is because within the US, the component real assets had a higher correlation with inflation compared to their euro area counterparts.

Performance And Correlation—Real Asset (January 2000 to May 2011)

Conclusion
The focus of this article is to understand the performance of inflation and inflation hedges for the Eurozone and to compare and contrast the performance with that of the US. The analysis results in three major conclusions.

First, to date in the 21st century, inflation has been low but not negligible. However, the performance of both TIPS in the US and GILB in the euro area indicates that investors expected otherwise. [Note: the performance of the Dow Jones Long-Term Inflation Index, which aims to provide a measure of the long-term inflation expectations in the US by capturing the difference in performance between the 30-year US TIPS and the 30-year US Treasuries, is a testament to this fact.]

Second, of all the asset classes analysed, commodities provided the best inflation hedge both in the US and euro area. In both the regions, energy was a big driver of the hedging capabilities of commodities while precious metals also played a role in the US.

Third, the composite real asset strategy was more successful at hedging inflation in the US than in the euro area. This is because inflation was more highly correlated with real assets within the US than in the euro area. This seems to indicate that inflation hedges within the euro area might differ from those in the US and suggests that the search for real assets within the euro area requires more research.

Sarah Paretti provided extremely able research assistance.



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