Trading the Inflation Theme

Introduction

While the holiday season has long been regarded as a time of excess, folks this year are bracing for another challenge besides annual waistline expansion: price inflation. As we gather with family and friends for the holidays in coming weeks many are predicting that this year’s turkey will be the most expensive in the history of the holiday with food prices having risen a remarkable 5.4% yoy.

It’s no secret that inflation has been on the rise in 2021 and with each passing day it becomes increasingly difficult to believe that it is merely “transitory”. In fact, there is little agreement amongst industry professionals as to whether inflation will remain a persistent feature in the years to come or if this period is merely an aberration in the long run deflationary trend that began in the 1980’s.

All of this has left investors unsure of how to invest in such an environment and little experience to draw upon.

In this article, I intend to outline the case for structurally higher inflation in coming years and how investors might consider reallocating their assets against a backdrop of rising prices and falling real rates.

The article will proceed as follows:

• Review the history of inflation in recent decades and the case for higher inflation going forward
• Assess the statistical evidence for how inflation impacts asset prices
• Evaluate the performance of inflation and deflation baskets

The Secular Case for Higher Inflation

To better understand the course that inflation may take in the future, we must first consider the historical context that has led to the present state of prices and why those conditions may be due to change.

As the below chart demonstrates, inflation has been broadly receding since it’s peak in 1981. During the most recent decade, prices were quite stable with inflation averaging about 2%. In fact, inflation routinely failed to reach the Fed’s 2% stated target and the concern (as recently as 2019) seemed to too little inflation rather than too much.

Factors responsible for the secular decline in inflation over the past 40 years include:

Central Banks

The Federal Reserve has stated that it believes an inflation target of 2% is broadly consistent with its dual mandate to maintain stable prices and maximum employment. The Fed formally adopted this target in 2012 in its inaugural “Statement on Longer-Run Goals and Monetary Policy Strategy”. Key to this policy framework was the adoption of a “symmetric” view of inflation and that the Committee would seek to mitigate “deviations” of inflation from its longer-run goal. By viewing deviations from target as critical, the Fed signaled that it would treat inflation both above and below 2% equally. This conservative approach sought to combat inflation immediately when it began to rise and is perhaps best evidenced by Powell’s infamous 2018 statement

Globalization and the Rise of China

Of all China’s exports, the most significant is arguably deflation. China’s introduction into the WTO in 2001 caused a wave of offshoring globally. Rightly or wrongly, “The China Price” became a euphemism for the cost paid by onshore industries for China’s rapid ascent over the past two decades. Consumer’s benefited from lower retail prices, and corporations experienced vast margin expansion, but wages faced downward pressure as China’s vast population was able to undercut the price of labor. Worker’s share of the economy’s production has also decline making prices less sensitive to wage pressures which has historically been associated with inflationary periods.

Technology

The 2010’s were the decade of the disruptor. Technology is the great deflationary force and in the past ten years, tech, has invaded every industry. Cloud computing massively brought down the costs of data acquisition and storage. The iPhone sucked in entire stores worth of product (phones, radios, cameras, camcorders, alarm clocks, CD players, TVs…bank branches) into a device that can fit in your pocket. Software ate the world.

Demographics

Economics is downstream from demographics. Recent research has sought to quantify the link between age and inflation and found that large increases in the working age population have generally been associated with declines in inflation across developed economies when controlling for other macroeconomic factors. Critically, the development of inflation over the past several decades has tracked the age structure of the US remarkably. Employment-to-Population and Labor Force Participation both broadly increased starting in the 1960’s as boomers and women drove a significant change in the overall labor pool; increasing productivity but depressing real wages.

By their nature, secular forces are necessarily slow moving. Any policy decisions that have contributed to disinflation were made decades ago and it is only now that we reap the consequences. With this in mind, we must consider what decisions made today will have on the future course of inflation.

The secular drivers of higher future inflation are:

Central Banks

Beginning in 2019, the Fed conducted a review of its monetary policy and longer-term goals framework. As fate would have it, 2020 brought the most significant challenge to monetary policy since the Great Depression and the Fed reacted in epic fashion [Link to Ocean of Money] with purchases by the central bank totaling ~$160MM per hour in 2020 and 2021. The changes the Fed made to its policy statement are instructive. As opposed to taking a “symmetric” or deviation-based view of inflation, the Fed has stated that they will now target an “average rate” of inflation:

“In order to anchor longer-term inflation expectations at this level, the Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.”

Moreover, the Fed’s comments concerning employment suggest the conduct of monetary policy will be substantially different going forward:

“The maximum level of employment is a broad-based and inclusive goal that is not directly measurable and changes over time… the Committee’s policy decisions must be informed by assessments of the shortfalls of employment from its maximum level… Committee considers a wide range of indicators in making these assessments.”

Rather than focusing exclusively on shortfalls of employment from the maximum level, the Fed will now seek to act in such a way that they will actively promote an inclusive economy whose benefits are more equally conferred upon the participants.

Taken together these revisions suggest a Fed that is more flexible and less conservative in its approach to policy and, critically, a Fed that is more comfortable with inflation running hot.

Debt

The US Federal budget deficit is expected to eclipse $2.3T in 2021 and debt-to-GDP is expected to reach 102%. Moreover, the annual deficit is expected to be between $1.2T-$1.6T from 2022-2031 and exceed the 50-average of 3.3% (as a percentage of GDP) in each of those years. By 2031, the US debt-to-GDP ratio is expected to reach 113% (see here and here). Notably, these projections do not incorporate any additional stimulus from the recent $1.2T Infrastructure Investment and Jobs Act or the Biden administration’s $1.85T Build Back Better (BBB) Act. These are some staggering figures to be sure and to the degree to which they raise the productive capacity of the US may yet be quite successful. What is likely however are price distortions in the short run.

Inequality

Closely linked to debt is inequality. The 2010’s witnessed a remarkable rise in the general degree of wealth inequity and COVID only further accelerated this trend. The share of wealth controlled by the Top 1% of the wealth distribution increased from ~30.8% at the beginning of 2020 to ~32.3% as of Q2 2021. All while the share of wealth controlled by the 50^th-99^th percentiles combined continued its secular downward spiral.

The research covering the link between inequality and inflation is relatively scare, but relevant studies covering this area suggest that there is a positive correlation between the two in cross country samples (see here and here). The logic being, politicians in countries with high inequality face incentives to choose high inflation policies in favor of redistribution or increase the asset prices of their wealthy constituents. While the motivation is unclear, the link is relatively persistent.

Part of motivation behind the BBB Act is to promote more inclusive participation in the fruits of the economy which dovetails nicely with language adopted by the Fed.

Inequality and debt work in concert to explain how inflation may develop going forward. Piketty summarizes this mechanism in Capital in the Twenty-First Century, p. 380-382. In brief, stoking inflation is a blunt but historically popular tool for reducing inequality since it erodes the real value of debt held by investors and reduces the effective amount owed by borrowers. As debt-to-GDP climbs, the federal government has an increasing interest in seeing the real value of debt fall. This also has the ancillary benefit of increasing the nominal wealth of average citizens whose primary store of value is their home; on which they often carry a mortgage.

Piketty repeated reminds us that inflation is an imprecise and imperfect tool, but one that has been used repeated in history by central banks in the US, Great Britain, France, and Germany in order to escape the burden of public debt. Indeed, the Fed’s intention to raise their inflation target coupled with legislation aimed at boosting social programs is consistent with a desire to use such tools again.

Globalization

The pandemic has exposed the hidden risks and costs of maintaining global supply chains. Economic nationalism, which began with the Trump tariffs and continues under the Biden admin, demands the reshoring of critical industries (semiconductors being a chief example) and the reorientation of global value chains. This translates to higher prices across a range of industries and greater sensitivity to the cost of labor.

Demographics

One of the more surprising outcomes of the pandemic has been the reluctance of people to return to work. The Great Resignation, as it has been called, has resulted in a dramatic decline in the labor force and put stress on businesses throughout the country. Of those nearing retirement who were laid off during the pandemic an estimated 2MM elected not to return to work-a-day life. The Labor Force Participation Rate has declined to levels not seen since the 70’s (the last period of significant inflation) and has been very slow to recover, which is suggestive of structural damage to the labor market. Moreover, research suggests that countries with a large proportion of recently retired is inflationary (again, see Juselius and Takats).

As we consider the case for structurally higher inflation in coming years it is important to recall one factor that is expected to work against this outcome: technology. Technology is deflationary by nature and the pervasiveness of technology in daily life will remain considerable, if not accelerate. It may be the case that tech and automation come to dominate the forces mentioned above to drive productivity gains and keep inflationary pressures at bay. This is an important context as investors consider how to trade the inflation theme.

Inflationary Expectations

Having outlined the case for higher inflation in the years ahead it is time to consider the impact this will have on portfolios and investor asset allocations. In general, investors can expect:

1. Low real yields: With nominal yields across fixed income at multi-century lows even a modest amount of inflation will eat up annual coupons. Yields on 10-year TIPS (which proxy for real yield) currently hover around -1% and inflation expectations are at the highest level observed since the series began in 2003. Investors are pricing in inflation and even if these levels moderate, we can expect real yields to remain paltry.
2. Low (Negative) returns in stocks and bonds: With stocks at near record valuations and bond durations just off all time highs the outlook for future returns is pretty bleak.
3. Greater volatility in bonds and stocks: High valuations imply not just low future returns, but also more volatile returns. High duration will make any adjustment in rates greatly amplified. Indeed, 2021 has been a difficult year for bonds with long dated Treasury’s posting negative returns YTD through November.
4. Real assets to outperform financial assets: Real estate and commodities are more levered to inflation than stocks and bonds and should be expected to outperform.
5. Value and small caps to outperform growth: It’s been a while since we’ve seen value outperform growth. The dominance of growth over everything in the last decade (and the last few years in particular) can be ascribed, at least in part, to declining yields which lower discount rates and prop of the valuations of “long duration” stocks (i.e., companies whose earnings accrue in the distant future). As these dynamics shift, investors should reallocate to value and small caps which are more correlated to inflation and have been historical beneficiaries.

Trading Inflation

To support these salacious claims and assess the likely impact inflation will have on asset prices I’ve gathered data from 1990 through present for 23 assets/styles intended to be generally representative of the investable universe (see Appendix for data sources).

The analysis to follow examines rolling 6-month returns for each asset and the rolling 6-month change in the Personal Consumption and Expenditures Index (PCE) which will serve as our gauge of inflation. Because monthly changes in economic indicators can be noisy, the rolling 6-month window was selected to more broadly demonstrate how asset prices react to a general change in the price level.

The plot below depicts the correlation of each asset to the change in inflation:

As might be expected, commodities are highly correlated with inflation. Indeed, many inflationary episodes throughout history (the present one included) have been caused by commodity price shocks. Gold, often considered a key inflation hedge, exhibits a relatively low correlation which is worth thinking about. For more on the drivers of gold returns see my post all about it!

Somewhat more surprising are the results for hedge funds which rank as the second most correlated asset class. Trend following commodity futures is a popular quantitative hedge fund trading strategy which may partially account for this apparent association. As a widely regarded store of wealth, real estate also ranks well with REITs exhibiting a distinctly positive correlation on both a price and total return basis. Interestingly, while REITs appear highly correlated with inflation, US Residential Housing (i.e., US House) does not demonstrate a pronounced association and ranks low on the list.

Turning to stocks, the results are more nuanced. Broadly speaking, US stocks are correlated with inflation, but there is significant dispersion within styles. Specifically, Low PB and Low PE stocks show the greatest correlation. Price-to-Book and Price-to-Earnings are the two most widely referenced measures of “value” and these results combined suggest that value stocks are significant inflation beneficiaries. High dividend stocks also rank well which may indicate that in an environment not conducive to bonds/duration investors may turn to companies that consistently pay and grow dividends as an alternative to traditional fixed income. Growth and High PB stocks, on the other hand, rank poorly and bolster the thesis that inflation is a key factor for explaining the growth-value performance differential.

Finally, we consider fixed income. Long dated Treasuries are the clear losers when inflation ticks up with both the 10- and 30-year note exhibiting a markedly negative correlation even when interest payments are accounted for. Short, dated Treasuries, such as the 2-year, appear unimpacted by inflation which makes sense as they essentially substitute for cash. On the corporate side, US Investment Grade holds up okay and appears basically uncorrelated with inflation while US High Yield is notably positive. Taken together the corporate bond universe may serve as a suitable alternative habitat for fixed income investors.

Statistical Analysis

Moving beyond simple correlation analysis, the following table depicts the results of a regression of each asset against PCE. Test statistics and p-values were computed based on heteroscedastic and autocorrelation corrected (HAC) standard errors and 372 degrees of freedom. The legend describes how significant is color coded.

In general, the results from the correlation analysis carry over. Apart from long-dates Treasuries, the Inflation Beta are uniformly positive for our list of assets and suggests that positive inflation is constructive for stocks while deflation is negative which conforms with our expectations a priori.

For Commodities, Hedge Funds and 30-Year Treasuries, inflation is highly statistically significant. For Commodities, approximately 70% of variance is explained by the change in PCE based on R-squared. For Hedge Funds, inflation explains about 12% of model variance, which, again seems remarkably high. Meanwhile for long dates Treasuries, inflation explains only about 5% of overall variance which suggests that while inflation is an important factor for determining the return from Treasuries, much is left unaccounted for.

Inflation is also highly significant for stock styles like Low PE, Low PB, High Dividend and International with a reasonable degree of explanatory power.

The below bar graph plots sorted inflation sensitivity as measured by Beta:

One might theorize that the impact of inflation on asset prices differs based on the level of inflation; that is, the impact is asymmetric. While mild inflation (around the Fed’s 2% target) may be constructive for risk assets, persistently high inflation may put pressure on firm’s margins and reduce earnings. Thus, a differential effect may exist that is not captured in the regressions we have looked at so far.

To investigate this claim we’ll now consider models of the following form:

Where:

• B₁ = Intercept
• B_2,>Med = Differential Intercept for when PCE > Median PCE
• B₃ = Sensitivity of Asset ‘i’ to PCE
• B_4,>Med = Differential Beta when PCE > Median PCE

B₂ and B₄ represent the differential slope and intercept coefficients, respectively. This specification is convenient because it allows us to determine if the differential impact (if one exists) is attributable to the intercept, slope, or both. If B₂ and B₄ are significant, then we can infer that asset prices react differently to high inflation.

The below table presents the result for the differential regressions:

Now these are some interesting results! If we consider the intercepts, we observe that the coefficients for B_1 are not statistically significant. In our first round of regressions, the intercept was significant for commodities, Treasuries, hedge funds, and US corp bonds. With the introduction of the diff intercept that effect has entirely disappeared. Contrast that with the results for the diff intercept B_2 which is significant across a broad cross section of stocks, real estate, and bonds. Except for 30-year Treasuries, the sign of B_2 is positive which suggests that asset price returns are structurally higher when inflation runs above the median.

Examining the slope terms B_3 and B_4, after having introduced diff betas for PCE > Median (i.e., B_2 and B_4) the coefficients for PCE (B_3) turned highly statistically significant across the board. In our prior regressions many of these same assets displayed significant results for PCE, but generally the coefficients were smaller in magnitude and of lower significance. Introducing the diff intercept suggests that inflation is much more important for assets than we may have previously thought. Examining the results for diff PCE, B_4, again we see the coefficients are largely significant for stocks, real estate, and real estate. Crucially, (again, apart from Treasuries) the coefficients are negative. Whereas the impact of inflation as measured by PCE is significant and positive the diff impact is negative and significant. This is indicative of a structural change in how asset prices react to inflation above the median and strongly supports the hypothesis we fist proposed.

Let’s look at the fitted plots for some assets to solidify these results visually:

The “kink” visible in the plots represents the structural change in the regression that occurs when inflation is above the median. For Low PE stocks and Hedge Funds you can see how “post-break” the regression is trending downward which suggests that while stocks still benefit from higher inflation the expected return declines as inflation gets progressively hotter. For Growth stocks, the change is quite visible. It is sometimes thought that Growth excels in an environment of low and stable inflation and these results lend that claim some support. In a relatively higher inflationary environment, we see Growth returns have historically broke lower and on average have been around 0; granted there is substantial variability around the realized return as the prediction interval suggests.

Performance: The Final Showdown

What has performed better over time: inflationary or deflationary assets? To whet the appetite, let’s take a look at the average return for our assets when inflation is above/below the median.

In the above plot, the teal bars depict the average return for assets when inflation is low (i.e., PCE below median) while the red bars show the average return when inflation is high (i.e., PCE above median). From a strict return perspective, when inflation is low Commodities, Gold, and International struggle while Growth, High PE/PB, and Treasuries do well. When inflation is high, assets generally seem to fair better with REITS, Small Cap, and Value categories leading.

To compare the long run performance of inflationary and deflationary assets we’ll consider two portfolios:

• Deflationary Portfolio (equal weighted)
  • 30-Year Treasuries
  • US Housing
  • US Growth
  • Low Beta
  • US Investment Grade
  • US High Yield
• Inflationary Portfolio (equal weighted)
  • Commodities
  • US Value
  • Small Cap
  • REIT TR
  • International Developed
  • 2-Year Treasuries

The below plot charts the cumulative return of the Inflationary and Deflationary portfolios from February 1990 to August 2021. As the graph makes obvious, the Deflation portfolio has decisively beaten the Inflation portfolio over the past three decades.

One might conjecture that perhaps the Deflation basket has outperformed because it is riskier. The below table tabulates the annualized return, volatility, and Sharpe Ratio for each portfolio. As it happens, not only has the Deflation portfolio produced higher returns, but has done so will about 60% the risk of the Inflation portfolio. On a risk-adjusted basis, the Deflation portfolio as a Sharpe Ratio over twice that of the Inflation portfolio.

Has the Inflation basket really underperformed that significantly? It’s true that commodities performed very badly during the 2010’s. Additionally, commodities are a difficult asset class to gain direct exposure to. Most investors are not comfortable trading futures and ETF based products offer imperfect access. Let’s modify the Inflation basket slightly by removing commodities and redistributing the allocation amongst the other 5 assets. The following chart depicts the cumulative return of the Deflation and Modified Inflation baskets:

Removing commodities aids the absolute performance of the Inflation basket. Indeed, you can see the post Tech Bubble period from ~2002 to 2007 when Inflation assets last had multi-year outperformance and the surging performance over the last year. Let us view the summary statistics:

Intriguingly, removing commodities makes performance worse in some respects. While the average annualized return has increased, so has volatility. The low correlation that commodities have with the other assets in the Inflation portfolio helped to bring down vol. Excluding commodities has historically resulted in Inflation portfolio having about twice the volatility of the Deflation portfolio and has brought down the Sharpe Ratio from .70 to .65. Even considering the slightly better absolute returns, the Inflation portfolio has markedly underperformed the Deflation portfolio which is…disappointing.

Concluding Remarks

In this post, we have gone deep on inflation. I detailed the reasons why inflation has receded over the past several decades and laid out the case for higher inflation in the years ahead. We examined the empirical evidence for how inflation impacts major assets and how those impacts have translated to performance in the context of a portfolio, but a question remains: how do best trade the inflation theme?

It’s a good question. Even if you believe (like me) that inflation will be higher for a period of time, I don’t think it will be a permanent phenomenon. The Fed’s long run target is still 2% which is inconsistent with long-run, sustained outperformance of inflation sensitive assets. So even if inflation runs hot for 1, 3, or 5 years it is unlikely to do so for 10 or more. Given the evidence we have seen, Deflation assets have outperformed Inflation sensitives handsomely over time.

So how best to balance these competing views? My approach is to keep it simple. Rather than try and market time to capture all the inflation beta and risk missing out on the long run outperformance of Growth I think a tilt is more appropriate. Many investors have fully committed to Growth stocks in recent years and positioning in Value, Small Caps and Commodities remains light. Consider reintroducing these components into your portfolio to catch these secular themes and are shaping up to be key market drivers in years to come.

If you have made it this far, I hope you found this post informative. Until next time, thanks for reading!

-Aric Lux.

Appendix

1. Gold (GOLDAMGBD228NLBM), Commodity (PPIACO), US Housing (CSUSHPISA), US Corp Investment Grade (BAMLCC0A0CMTRIV), and US Corp. High Yield (BAMLHYH0A0HYM2TRIV) price and total return indices were retrieved from the Federal Reserve of St. Louis FRED Database. Identifiers are in parentheses.
2. High/Low Beta, High/Low PE, High/Low PB, High Momentum, and Small Cap returns were retrieved from Kenneth French’s Data Library.
3. REIT Price and Total Return Indices were retrieved from the National Association of Real Estate Investment Trusts online data portal.
4. US Value, US Growth and International price indices were retrieved from the MSCI online data portal.
5. Hedge Fund total return indices were retrieved from the HFRI online data portal.
6. Treasury yields data was obtained from the FRED Database. Return indices were derived using R and the ‘treasuryTR’ package developed and maintained by Martin Geissmann. Available on CRAN.