Performance in quarters of unexpectedly high inflation, April 2002–March 2022
Notes: For our analysis, we classified each quarterly period as a positive or negative surprise by looking at the value of the Citi Inflation Surprise Index, which is an accumulation of headline CPI, PPI, and wage surprises relative to median expectations of professional forecasters. A positive reading means that releases have been better than expected, while a negative reading means that releases have been worse than expected. Next, we defined each period as having unexpectedly high inflation if the positive surprise fell within the top 50% of quarterly observations, which was roughly 20% of the time over this period.
Sources: S&P Dow Jones, MSCI, FTSE Russell, Bloomberg, and Parametric, as of 5/24/2022. Diversified commodities represented by S&P GSCI Equal-Weight Select Index, US equities represented by MSCI USA Gross Return USD Index, US fixed income represented by Bloomberg US Aggregate Bond Index, TIPS represented by Bloomberg US Treasury Inflation-Linked Bond Index, REITs represented by FTSE Nareit All Equity REITs Total Return Index. For illustrative purposes only. Past performance is not indicative of future results. It is not possible to invest directly in an index.
Commodities outpunch their weight when it comes to inflation protection
An important consideration when adding inflation-sensitive assets to a portfolio is how much protection you’re getting. A common technique to assess this is to estimate an asset’s beta against the CPI, which measures how much returns for the asset change with a one-unit change in inflation. For example, a beta of one would indicate that if inflation was 1%, the asset would produce a return of 1%. When it comes to inflation protection, a higher beta is better because it translates into greater protection across the entire portfolio. The following chart contains beta estimates for common asset classes versus CPI over the past 20 years.
Quarterly beta against CPI for selected asset classes, April 2002—March 2022
Sources: S&P Dow Jones, MSCI, FTSE Russell, Bloomberg, and Parametric, as of 5/24/2022. Commodities represented by S&P GSCI Equal-Weight Select Index, US equities represented by MSCI USA Gross Return USD Index, US fixed income represented by Bloomberg US Aggregate Bond Index, TIPS represented by Bloomberg US Treasury Inflation-Linked Bond Index, REITs represented by FTSE Nareit All Equity REITs Total Return Index. For illustrative purposes only. It is not possible to invest directly in an index.
Commodities have a well-earned reputation for their high degree of inflation sensitivity, which has some important implications when it comes to considering how much to include in an overall portfolio. For most investors seeking broad protection, a useful starting point is to consider how much of the portfolio has a low beta to inflation. An allocation to commodities can help plug this gap. For instance, if 40% of the portfolio is in fixed income, which has a low inflation beta and generally underperforms when inflation hits, a 5% allocation to commodities could do the trick. That’s because commodities would be expected to outpace inflation by a factor of eight, offering protection on up to 40% of a portfolio (5% × 8). A portfolio with fewer inflation hedging assets may require a modestly larger commodity slice, and vice versa.
The bottom line
Most portfolios already carry allocations to more traditional assets like stocks, bonds, and cash but may lack exposure to assets that do well during periods of unexpectedly high inflation. In this inflation environment, however, an investor’s portfolio may be most vulnerable. Not only can its purchasing power be eroded by higher-than-expected inflation, but its market value may also be eroded by falling stock and bond prices. Investors looking to hedge this risk can be best served by increasing their exposure to asset classes with a positive expected return when unexpectedly high inflation hits. Historically, commodities have served this purpose well, outperforming other asset classes when inflation has been unexpectedly high. Given the asset class’s high sensitivity to inflation, a modest allocation in a diversified portfolio is often all that’s needed to mitigate this risk.