Last week’s unexpectedly high inflation report tripped up the stock market. The fear is that inflation will push the Federal Reserve to hike interest rates sooner than it current projects (in late 2023), observes Marvin Appel, editor of Signalert Asset Management's Systems & Forecasts.

In fact, the Fed’s continued sanguinity in the face of the 4.2% jump in consumer prices over the past year is leading some commentators to worry that inflation will get out of the Fed’s control for the first time since the early 1980s.

If that occurs, where should you invest? The usual recommendations for a high-inflation environment include commodities and gold. Other areas that have been good include real estate and materials stocks. 

The chart below shows how different areas of the stock and commodity markets have performed since 1970 grouped by the level of inflation. An important takeaway is that investments that did well when inflation was in the 3%-6% range (27% of the time) were not necessarily the same ones that did well when inflation exceeded 6%/year (16% of the time).

hedge

This appears the most likely outcome of the Fed’s stance, especially since Fed Chair Powell has promised to tolerate inflation above 2% for an extended period to bring its long-term historical average up to 2%. In this range of inflation, the following areas have performed well:

    •  U.S. stocks and value stocks
    • Oil, and energy stocks
    •  Real estate
    •  Base metals, and materials stocks
    •  Agriculture

It is good news for investors that a diversified portfolio of U.S. equities has still performed well in this inflation range. That means that you don’t have to make potentially risky sector bets even if inflation heats up. 

The problem with many inflation hedges is that, in contrast to U.S. stocks, they have not performed well when inflation was under control. The table presents the performance of potential inflation hedges from early 2007, with each group of related ETFs shaded in a different color.

type

Note that ETFs based on commodities futures lost money over the long term.  This is because investing in commodities futures burdens you implicitly with the cost of storing the commodity so that you are losing money even in a flat market. (This is called contango, when futures for later delivery trade for more than futures for earlier delivery.) Stocks in commodity producers have done better than the commodity futures themselves.

In the case of precious metals, ETFs are available that represent ownership of physical bullion where storage costs are very low. As a result, long-term holdings in gold (GLD) and silver (SLV) have performed reasonably well, in fact better than gold mining stocks themselves (GDX).

For base metals, neither the commodities futures (DBB) nor the stocks (XME) have performed well over time.  The Basic Materials Sector SPDR (XLB) has done well, but 2/3 of that ETF is in chemical companies. 

Permanent Portfolio Fund (PRPFX)

This mutual fund aims to preserve purchasing power. Its portfolio includes gold (20%), silver (5%), Swiss Franc assets (7.6%), real estate and natural resource stocks (21.5%), aggressive growth stocks (19.5%) and dollar assets (25.6%, mostly short-duration corporate bonds).

The fund has had about half the risk of the S&P 500 Index in terms of both monthly standard deviation and worst drawdown (27% in 2008 compared to 55% for SPY). During the first quarter of 2020 the fund had a 20% drawdown.

The fund has a long-term average return of 6.9%/year from 1988-2021, which is good considering the level of relative safety. In fact, years ago we used this fund for a number of our clients as a core, lower-volatility holding. However, PRPFX made just 3.2%/year from 2011-2019, demonstrating that, as with many potential inflation hedges, if the economic climate turns out not to be inflationary you won’t make much money.

Inflation above 6%

Unfortunately, in the highest inflation environment almost every investment has performed worse than when inflation was less than 6%. The exceptions were gold and real estate.

Implications

For investors looking to make long-term bets to hedge against inflation, the most appealing options on a risk-adjusted basis appear to be:

      • Permanent Portfolio (PRPFX) — the inflation hedge with the lowest historical volatility
      • S&P 500 SPDR (SPY) — simple is often best
      • Real estate (either direct investing if you know the local market or through REITs such as IYR)

Commodity-related equity investments such as MOO (agriculture) or XLB (basic materials) have done well but are even more volatile than the broad stock market. ETFs based on commodity futures (or direct long-term exposure to long positions in commodity futures) have been money losers.  Futures traders need to be tactical rather than maintaining a constant long exposure.

The inflation trade seems already to be quite crowded, so in my opinion if you are worried about inflation the best way to protect yourself is to hold PRPFX as a long-term core holding and to trade SPY.

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