Rabo TransAct

With lowflation entering the lexicon and the European Central Bank and the Bank of Japan working to stave off deflation, this might not seem the most appropriate time to be focusing on how to hedge against inflation risk. But that hasnt stopped Rabobank senior market economist Emile Cardon from putting together a fascinating look at how everything from stocks to bonds to gold to real estate fare in an inflationary environment.

And its well worth keeping in mind. Cardon acknowledges that high levels of spare capacity make it unlikely industrialized economies will see a sudden bout of inflation soon. Still, the ultimate impact of unprecedented monetary experiments by the worlds major central banks fall under the category of potential black-swan events, Cardon says, noting that investors should also ask themselves when, exactly, it is a good time to buy a hedge?

The table above illustrates the correlation between nine different assets and four measures of price pressures. The first column tracks the correlation with expected inflation, while the two middle columns track unexpected non-core inflation (such as oil shocks) and unexpected other inflationary pressures. Finally, the far-right column tallies the assets correlation with total inflation.

The table uses historical data ranging from 1977  through 2013. As it shows, the 3-month Treasury bill is the best hedge against total inflation with an investment horizon of one year. Thats probably not a shocker, Cardon acknowledges, due to the T-bills short maturity. On closer examination, however, its interesting to note that the return on the 3-month T-bill /quotes/zigman/4868356/delayed 3_MONTH. while also correlated to expected inflation and unexpected other  inflation is negatively correlated to non-core inflation.

At the same time, its hardly a shock that oil is best correlated to non-core inflation, while returns on gold  and real estate are significantly correlated to all three types of inflation, Cardon notes. Meanwhile, equity and common government-bond indexes offer a rather poor hedge against inflation risk in the short run, he says.

So if you decide to worry about inflation, whats the single best asset to use as a hedge? Sadly, Cardon says its not so simple:

We conclude that “the” best hedge against inflation does not exist, but merely depends on what kind of inflation the investor wants to hedge. It also depends on the time horizon being considered. Our analysis focuses on short term hedges, whereas investors with a longer term investment horizon are perhaps better off via other investment products. For example, government bonds might not be an appropriate hedge against short term inflation, but for longer term purposes, as our literature study also indicates.

William Watts

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