Hedging against inflation (part 2)

According to IDEA, “since common stocks often offer higher returns than fixed-income instruments do, some analysts believe that it is a good inflation hedge. Based on historical performance, however, equities and fixed-income assets often yield lower returns during high inflationary periods. Since common stocks represent ownership of real physical capital, their rate of return is higher than inflation in the long run.

By staking a claim on real capital, owners of common stocks find refuge from high inflation. In a 1976 Zvi Bodie study, stock returns in the United States were found to be negatively correlated to a small degree with historical inflation.

Because of this, doubts remain whether common stocks can really be an effective inflation hedge, most especially in the short run. Its main strength is the likelihood that it yields higher returns in the long run compared to commercial paper. This potential for bigger earnings, however, also comes with the possibility of higher loses in instances when a crisis hits the financial sector, as now seen in the US.”

Furthermore, according to the same report, “except during the first and second oil price shocks, the S&P 500 generally generated higher returns, way above actual inflation. Because of the stock market’s historical performance, some investors continue to believe that this particular asset is a good inflation hedge. Like other commodities, the verdict on whether real estate offers better options for investors remains to be seen.

Unlike gold, however, real estate assets suffer from poor liquidity, making it problematic for investors to leave the property market once volatility sets in. Based on a 10-year average, the returns of the NCREIF index reached 12.7%, way above the S&P 500’s 8.4% and the 91-day treasury’s 3.6% yield.

Like in all other assets, historical performance is no guarantee of future performance. In the case of real estate, the mode of acquisition of the property becomes a crucial factor. Unless paid in full, real estate depends on mortgage financing which often have adjustable mortgage rates (AMRs).

This becomes problematic since investors face interest rate risks, possibly wiping out their returns and putting them deep into debt. This is one hard lesson property owners now face in the face of the ongoing mortgage crisis that has put the US economy in a likely recession.”

Overall it was reported that “to become effective inflation hedges, assets need to be able to maintain their value in the face of high inflation. Decades before the introduction of the index-linked bonds, gold was considered to be the best inflation hedge.

This belief largely explains gold price movements during the 1970s and 1980s. The onset of the US Treasury’s TIPS and other similar index linked bonds have reduced the place of gold as an important inflation hedge. Given other issues such as tax obligations and asset allocation, investors will have to be more careful in making decisions especially now in a highly uncertain environment” according to IDEA.

For credit & collection (C&C) questions, comments and rejoinders you want to share or inquire, you can reach him at 0917-7220521 or at [email protected]