How to hedge against inflation

By Lukas Brandl-Cheng, investment strategy analyst, Vanguard, Europe

• Inflation is expected to remain above target levels through 2023.
• Global equities are forecast to offer the best chance of beating inflation over the long-term.
• Traditional inflationary hedges like commodities can help protect portfolios against unexpected jumps in inflation—but only for as long as the inflationary pressures remain.

There’s no hiding the fact that investors face a challenging environment in the year ahead. Despite aggressive fiscal measures by central banks to rein in inflation, we expect pricing pressures in most developed economies to remain above target levels until 2024 or 2025.

There’s no one-size-fits-all solution for hedging against inflation

In such uncertain times, advisers may be tempted to tilt client portfolios towards inflation-hedging assets to protect them from the corrosive impact of inflation on portfolio returns. Yet there’s no one-size-fits-all solution to inflation hedging, and the potential benefits will depend on each individual client’s objectives, investment horizon and risk tolerance.

The chart below breaks down the inflation-hedging properties of major asset classes based on their forecasted 10-year real returns (y-axis) and ‘inflation beta’ (x-axis). Inflation beta measures the relative sensitivity of an asset to changes in inflation.  Unlike correlation, which only captures the similarity in direction between an asset’s returns and inflation, inflation beta captures both the direction and the magnitude of their co-movements. A beta score of one means the asset’s price moves, on average, exactly in lockstep with the rate of inflation.

Additionally, the size of the bubbles represents each asset’s expected average volatility over the next ten years.

The inflation-beating qualities of different asset classes

Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.

Notes: The chart compares real (inflation-adjusted) return projections over the next 10 years to the inflation beta for various asset classes. Inflation beta is the slope coefficient of a linear regression of the year 30 return forecast on a constant and the year 30 UK inflation forecast. The size of each bubble represents the forecasted median annualised volatility over the next 10 years. Asset-class returns do not take into account management fees and expenses, nor do they reflect the effect of taxes. Returns do reflect reinvestment of dividends and capital gains. Indices are unmanaged; therefore, direct investment is not possible.
For further details on the individual asset classes, please see the Vanguard Economic & Market Outlook 2023.

Source: Vanguard calculations in GBP, as at 30 September 2022.

We can see that global ex-UK equities are expected to outperform other asset classes over longer periods of time, with a forecasted median 10-year annual real return (after inflation) of 4.11%. Commodities, on the other hand, are expected to provide an average annual real return over the next ten years of only 0.80%.

For clients looking to generate a positive real return over a longer time horizon, equities—especially if globally diversified—have historically provided the best chance of beating inflation^1,2.

For clients with a shorter investment horizon, commodities and other traditional inflation hedges can help maintain purchasing power by matching the impact of inflation on portfolio returns. Commodities have a higher inflation beta than other asset classes, and their prices tend to respond quickly to inflationary shocks.

However, assets with high inflation betas don’t come risk-free. Commodities introduce additional volatility (as indicated by their larger-sized bubble in the chart), that can leave portfolios vulnerable to swings in value, which may not be suitable for clients with shorter investment horizons.

Commodities: Short-term gain but long-term drain 

In previous periods of high inflation such as the 1970s, commodities provided a useful inflationary hedge against the spiralling costs of energy and other goods. Yet our research indicates that when commodities are held for extended periods, they’re likely to have a negative impact on portfolio returns.

The following charts show the impact of an inflationary shock in year 1 (left-hand chart) and the impact of a more persistent shock over years 1-3 (right-hand chart) on nominal forecasted commodity returns over time. We can see how commodity prices (represented by the green and red lines) tend to respond quickly to the shocks, but only for as long as the inflationary pressures remain. After inflation subsides, commodities tend to act as a drag on returns, relative to holding a diversified portfolio of equities and bonds.

For clients, this means having to correctly time their entry into and out of their position if they are to realise the full benefit of holding commodities as an inflation hedge—otherwise they’re likely to experience lower total returns over the long term relative to having made no changes to their original diversified portfolio. 

Further to that, inflationary hedges incur a certain level of forecast risk; should a high-inflation scenario not play out as expected, the hedging position will likely underperform its forecasts while also leaving the portfolio to miss out on the potential upside from equities over the same time period.

Commodity returns are sensitive to inflationary shocks but can decay quickly 

Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.

Notes: The chart shows the impact of a shock to inflation and the Vanguard leading economic indicator (VLEI) on nominal commodity returns in GBP (unhedged) over time, based on the distribution of return outcomes from the VCMM derived from 10,000 simulations. The dashed red line shows the baseline VCMM forecast. The green line and shaded area in the left panel show the impact of a temporary shock increasing inflation in year 1 by one standard deviation and increasing VLEI in year 1 by 0.5 standard deviations.

The yellow line and shaded area in the right panel show the impact of a persistent shock increasing annualised inflation over years 1-3 by one standard deviation and increasing VLEI in years 1-3 by 0.5 standard deviations.

Source: Vanguard calculations in GBP, as at 30 September 2022.

Diversification offers the best long-term protection against inflation

Sometimes the best course of action is no action, especially when it comes to investing over the long-term.

We believe that a diversified portfolio gives clients the best odds of beating inflation over the long run, even in a high-inflationary world. Time and again, equities have proven the best diversifier against the pressures of inflation and have ultimately outperformed other asset classes¹.

Looking ahead, concerns about inflation and economic growth mean financial markets are likely to remain volatile in the coming year. Yet even when markets move sharply downwards, advisers should avoid the trap of having to take action. History has taught us that helping your clients maintain a diversified portfolio and keeping them focused on their goals will ultimately provide them with the best protection against inflation over the long term.

Notes

¹ According to Vanguard research, the average annualised real returns for UK and global ex-UK equities have been 2.1% and 4.1%, respectively, for the period from 31 March 2000 to 30 November 2022. UK and ex-UK equities outperformed UK bonds (1.5%), hedged global ex-UK bonds (1.8%), UK short-term inflation-linked gilts (1.3%), commodities (1.1%) and cash (0%) for the same time period. Source: Vanguard calculations, based on data from Refinitiv.

² As long as domestic and foreign inflation correlation is less than one, foreign equities will serve as an effective inflation hedge. This is because higher local inflation should cause the local currency to depreciate which would raise foreign equity returns, all else equal (Rodel, 2014).

Investment risk information

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

Past performance is not a reliable indicator of future results.

IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. VCMM results will vary with each use and over time.

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