The Inflation Hedge Myth

Thought you could hedge your inflation risk with equities, commodities, and infrastructure? Think again.

Only one asset class can claim to be a true and complete hedge for the inflation risk in your portfolio—and there's not enough to go around, research by the Institute and Faculty of Actuaries has found.
Speaking at the organisation's annual risk and investment conference in Brighton, UK, this week, two members from a working party set up to analyse how investors can match this liability had some bad news.
"What has been sold as inflation-linked hedges, we struggle to match with the claims," said Ralph Frank, founder of solutions provider Charlton Frank and Mercer alumnus. "Looking at the UK market alone, there is comfortably £1.5 trillion in inflation liability. This working group was set up to help investors come to their own conclusions on the best match from a range of asset classes."
Frank and Lukas Steyn, a member of the Pensions Solutions Team at Barclays explained to attendees at the conference that each asset class had different aspects, which would make them a better or worse fit as an inflation hedge.
"The most robust hedges are index-linked gilts, along with breakeven inflation swaps," Steyn said. "The maturities for the index-linked gilts may not match exactly, but taking a number of factors into consideration, these two instruments are typically the most robust hedges."
Investors know this; they also know the problem comes with supply. There is barely £450 billion of these government-backed debt instruments in the UK, which is one of the biggest markets, leaving a shortfall of more than two thirds. It translates into a similar picture around the world, which has meant investors have been looking to other asset classes for options.
What about international government-backed debt instruments? No so fast, the working group said. "There is about $2 trillion in overseas, government-backed, inflation-linked bonds, but they are unlikely to have the same profile as foreign investors' liabilities," said Steyn. "Then there is the political, repatriation, and currency risk to consider."
As an aside, if your fund has liabilities in Brazil, it is worth noting that the country has been issuing government-backed, inflation-linked debt since the 1960s and has about $250 billion outstanding.
Inflation-linked corporate debt is a useful option, the group found, but there is very limited issuance and investors have credit default and liquidity considerations to take into account with this asset class.
Let's leave fixed income then. Equities—the price of a stock goes up, that's a proxy for inflation isn't it?
"No," said Frank. "Equities are not a meaningful hedge, despite historical thinking. We have looked at data back to the 1960s, which is as far back as total return records go. Look at first principles: equities are at the bottom of the capital structure, you're only owning a stake in a company—and a pretty risky one at that."
Mining and resources companies? Not much better, according to Steyn, who dispelled the myth of commodities as a perfectly hedging inflation risk.
"There is no link between commodity prices and inflation, despite historical thinking. They provide an input into the overall inflation basket, but the direct link is too small to have a meaningful impact," he said.
In the event of a commodity shock, such as an oil price spike, the input plays a larger role, but these happen relatively occasionally and should not be used as a guide.
And the poster-child of inflation-linked assets—infrastructure?
"What is infrastructure?" asked Frank. "The debt part can be viewed as corporate, inflation-linked, which we have already covered, and the equity part, well, we have looked at this earlier, although income may be linked to inflation, as part of a corporate structure, which includes incentives for directors, and internal costs, so you might find what you earn is different to what you thought."
Members of the audience proffered other suggestions, such as agricultural land, which were all broken down by the pair, and placed into buckets already covered by the presentation.
Frank and Steyn repeated that they did not offer solutions to the dearth of inflation-linked products, but invited investors to read their paper on the subject to make up their own minds on what to choose.
That paper, including methodology behind all of the conclusions above, will appear here soon.
Related content: Who Cares about Inflation?