Financial markets expect a certain level of inflation and factor it into the asset prices they set, a condition theoretically neutral for investment portfolios. Unexpected inflation, on the other hand, can erode portfolios’ purchasing power, a challenge especially for investors with a shorter investment horizon, such as retirees.

Do certain asset classes weather unexpected inflation, like we’ve seen recently, better than others? Recent Vanguard research suggests that commodities stand apart as a vehicle for hedging against unexpected inflation.

Over the last three decades, commodities have had a statistically significant and largely consistent positive inflation beta, or predicted reaction to a unit of inflation. The research, led by Sue Wang, Ph.D., an assistant portfolio manager in Vanguard Quantitative Equity Group, found that over the last decade, commodities’ inflation beta has fluctuated largely between 7 and 9. This suggests that a 1% rise in unexpected inflation would produce a 7% to 9% rise in commodities.1

Commodities’ inflation-hedging power has been strong and consistent

The illustration shows that the Bloomberg Commodity Index has had an unexpected inflation beta consistently in a range of 7 to 9 in the last decade.
Notes: The blue line represents the rolling 10-year beta to unexpected inflation of the Bloomberg Commodity Index. The chart’s shading reflects the significance of the inflation beta, with darker shades corresponding to greater significance. Inflation beta significance is a statistical measure determined by both the magnitude and volatility of the beta. Inflation beta with greater significance has a larger potential impact as a hedging mechanism.
Sources: Vanguard calculations, using data from Bloomberg and the University of Michigan Surveys of Consumers through March 31, 2021.

Do other asset classes offer hedges against inflation? Nominal bonds certainly don’t, as a simple fact of mathematics. “You may not be able to predict the direction of interest rates, but the moment interest rates move, you know exactly what’s happening with your bonds,” Ms. Wang explained. “There’s not much uncertainty. Increases in inflation lead to higher rates, and bond prices decrease.”

Inflation-protected bonds are by their nature intended to hedge against inflation. But with a far lower beta to unexpected inflation (around 1), they would require a significantly higher portfolio allocation to achieve the same hedging effect as commodities.2

The discussion about equities as an inflation hedge is trickier. Our research reveals a sharp contrast in the hedging power of equities compared with that of commodities. “Equities have a love-hate relationship with unexpected inflation,” Ms. Wang said. The contrast presents itself as an inconsistency manifested in three distinct stages over the last three decades.

Broad stock index is not a consistent hedge against unexpected inflation

The illustration depicts three distinct stages for the Russell 3000 Index based on its unexpected inflation beta: a stage of negative betas in the post-Volcker 1990s era; a stage of higher but often still negative betas in the 2000s after the dot-com bubble burst; and positive unexpected inflation beta in a range around 3 to 6.5 in the 2010s.
Notes: The blue line represents the rolling 10-year beta to unexpected inflation of the Russell 3000 Index. The chart’s shading reflects three distinct stages in the last three decades where unexpected inflation beta has undergone a marked shift.
Sources: Vanguard calculations, using data from FTSE Russell and the University of Michigan Surveys of Consumers through March 31, 2021.

The 1990s marked the “hate” stage of the love-hate relationship, Ms. Wang said. More than a decade after the Federal Reserve under then-Chairman Paul Volcker raised interest rates to double digits to combat inflation, the Russell 3000 Index, which represents about 98% of the U.S. equity market, had an unexpected inflation beta ranging from around negative 2 to around negative 9. That means a 1% rise in unexpected inflation would equate to a 2% to 9% decline in the index.

The index’s unexpected inflation beta increased and at times turned positive in the 2000s, after the dot-com bubble burst. In the low-growth, low-inflation era of the 2010s, the markets determined that a little inflation wouldn’t be a bad thing, and the unexpected inflation beta turned positive and stayed there. “Any signs of inflation after the global financial crisis were a positive signal for equities,” Ms. Wang said. The beta has remained positive but has weakened in recent years, suggesting a market less sanguine about what inflation might mean for returns in the years ahead.

The Vanguard research additionally finds that U.S. equities’ hedging power is likely to decrease in the future, as commodity-related sectors including energy and materials constitute far less of the equity market, and sectors such as technology and consumer discretionary—not effective inflation hedges—constitute more relative to three decades ago.

Unexpected inflation and portfolio considerations

The asset allocation team within Vanguard Investment Strategy Group is thinking about unexpected inflation—and many other drivers of portfolio returns—as it maximizes the capabilities of the Vanguard Asset Allocation Model (VAAM).

Additional Vanguard research introduces a new methodology for building high-income portfolios that allows for yield targeting. The team could turn its attention to targeting for unexpected inflation beta as well, said Todd Schlanger, a senior investment strategist and lead author of the forthcoming research.

The VAAM takes input from the Vanguard Capital Markets Model®, Vanguard’s proprietary forecasting tool, to optimize portfolios based on investors’ risk preferences. “Typically, model portfolios are built in an ad hoc, suboptimal manner,” Mr. Schlanger said. Unfortunately, he said, such an approach might ignore portfolio construction best practices used in model-based solutions, such as VAAM, that are more systematic.

A methodology targeting unexpected inflation could take several thousand potential portfolios and rank them by their inflation beta, filtering out portfolios that don’t meet the criteria, Mr. Schlanger said. That would allow VAAM to determine the optimal allocation of an asset class such as commodities relative to portfolios’ unexpected inflation beta, for example, while also considering the portfolios’ total returns and diversification, he said.

Ms. Wang emphasized that portfolio considerations are in regard to unexpected inflation, not to inflation that the market has already accounted for in asset prices, and that the idea is to hedge against inflation, not to beat it. An investor whose goal is to beat inflation wouldn’t be concerned about potential medium-term erosion of purchasing power, she said. Instead, they’d need to have a very long investment horizon.

1The Vanguard research is based on the Bloomberg Commodity Index, which reflects futures price movements of commodity sectors including energy, grains, precious metals, industrial metals, livestock, and “softs,” such as coffee, cocoa, and sugar.

2The total return of the Bloomberg Commodity Index consists of commodity return and the return on collateral used in futures contract purchases. The Vanguard research found that using Treasury Inflation-Protected Securities (as opposed to three-month Treasury bills) as collateral increased the unexpected inflation beta of the Bloomberg Commodity Index.


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