23 Jun Inflation Risk: Factor Exposures and Gold
Inflation Risk: Factor Exposures and Gold
- Exposure to risk factors is unlikely to preserve the value of an equity portfolio when inflation is elevated.
- Gold has generated real returns that are higher than risk factors when inflation is elevated.
- Risk factors and gold are not correlated with inflation.
- The value factor does not consistently generate positive real returns when inflation is elevated.
Over the long-term, stock market returns are neutral to inflation.1 However, during short periods, returns are related to inflation. Many have demonstrated that nominal stock market returns and inflation are negatively correlated.2
What is an Inflation Hedge?
An inflation hedge should insure against the loss of portfolio asset value due to increasing prices. But, what is an inflation hedge? An interesting description3 of an Vincent Childers, CFA, in “Inflation Hedging Strategies,” suggested that an inflation hedge is an asset or security with all of the following characteristics:
(1) positive real expected return;
(2) volatility less than or equal to the equity market long-term average (~14%); and
(3) positive correlation with inflation.
While a positive real return is a common requirement, volatility and correlation are interesting additions. Using this definition, we considered if equity factors would qualify as inflation hedges.
Factors as Inflation Hedges
The Fama/French 5 factors do not qualify as inflation hedges. The following analysis assumes that inflation is the realized month-to-month change in the U.S. Consumer Price Index for all items.3 Table 1 shows that during periods of high (or above median) inflation (1) the 5 factors generate negative real returns; (2) the average volatility tends to be lower than the equity market’s long-term average; and (3) the correlations with inflation tend toward 0.
A classic inflation hedge like gold generates a positive real return with volatility above the equity market average and minimal correlation with inflation.
Relative to gold, the factor premia are less volatile and more correlated with inflation, but their real returns are lower.
Stagflation
From 1966 to 1982, the U.S. experienced high inflation with low rates of growth in real output. The inflation trend crested in August 1981 at an annualized rate of 11.9%. The S&P 500 suffered 2 major declines: (1) -48.2% in 1973–74; and (2) -27.1 % in 1980–82. Unfortunately, factors would not have contributed to hedging the persistent inflation trend of the time.
Value as Inflation Hedge
Other value measures, like the value premium (High Minus Low) shown above, have failed to provide safe harbor when inflation is high. Focusing on earnings yield (E/P), it generated positive real return during 2 of 5 periods of high inflation from 1966 to 2021. One period in 2005 lasted 2 months and an earnings yield portfolio generated 1.8%. The other period lasted 6 months and occurred in 2006. The portfolio generated 4.5%. Volatility was below the long-term market average. The portfolio had minimal correlation with inflation.
Conclusion
Inflation hedges tend to be assets and securities that generate positive real returns during high inflation periods. Augmenting the definition to include volatility and inflation correlation disqualifies gold as an inflation hedge. Likewise, equity factors based on the Fama/French 5 factors fail to qualify. Therefore, a portfolio with positive exposures to these factors may lose value when inflation is elevated.
1 See Siegel, Jeremy. Stocks for the Long Run, (McGraw-Hill Companies, 2008) (defining long-term as 1875 – 1970).
2 Erb, Claude B., Campbell R. Harvey, and Tadas E. Viskanta. 1995. “Inflation and World Equity Selection.” Financial Analysts Journal, vol. 51, no. 6 (November/December):28–42.; Fama, Eugene F. 1981. “Stock Returns, Real Activity, Inflation, and Money.” American Economic Review, vol. 71, no. 4 (September): 545–565.
3 See Childers, CFA, Vincent. 2012. “Inflation Hedging Strategies.”
4 Organization for Economic Co-operation and Development, Consumer Price Index: Total All Items for the United States [CPALTT01USM657N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CPALTT01USM657N, May 29, 2021.