The ‘unique’ investment that protects against inflation

Only one asset class has a positive correlation with rising prices, according to new research. Sam Benstead analyses the findings. 

With inflation returning to the agenda in 2021 and continuing to present problems for stock pickers and policymakers, finding investments that can protect a portfolio against rising prices has become a priority for many.

But many of the go-to inflation hedges have failed in the past couple of years. For example, index-linked bonds, where coupon payments are linked to the RPI inflation index in the UK, crashed in value as interest rates rose. Gold, which is also sensitive to interest rates changes as it pays no income, spiked when the war in Ukraine broke out, but is largely flat since the end of 2021.

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In the stock market, it is common to hear that consumer staple stocks, which have pricing power, should hold up well during inflationary spikes. However, their share prices move on more than just inflation statistics, and are vulnerable to wider stock market panics and slowing economies.

But there is one proven hedge against inflation, according to new research looking at more than 120 years of financial data.

The Credit Suisse Global Investment Returns Yearbook 2023, written by London Business School professors Elroy Dimson, Paul Marsh and Mike Staunton, found that a diversified basket of commodities, owned via “futures” contracts rather than physically, which keeps costs down, was the secret sauce when fighting inflation.

They said: “Our finding is that while investing in individual commodities have themselves yielded very low long returns, thanks to the power of diversification, portfolios of commodities futures have provided attractive risk-adjusted long-term returns.

“They have also provided an effective hedge against inflation. We found that commodity futures are almost unique in this respect”.

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Their calculations showed that an equally weighted basket of commodity futures had a positive correlation of 0.21 with inflation. This means that as inflation rises, the commodity basket rises by a fifth of that amount.

They add: “Historically, commodities have had a low correlation with equities and a negative correlation with bonds, making them effective diversifiers. They have also provided a hedge against inflation. Indeed, commodities are unique in this respect, compared with the other major asset classes. However, their inflation-hedging properties also mean that, in extended periods of disinflation, they tend to underperform.”

Interactive investor includes the WisdomTree Enhanced Commodity Ucits ETF in its Super 60 investment ideas. It offers broad exposure to commodities as an asset class, covering four broad commodity sectors: energy, agriculture, industrial metals and precious metals.

This passive fund uses futures to track the performance of the individual constituents of the Bloomberg Commodity Index and charges 0.35%. Its value has risen 42% over the past two years.

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The researchers push back against the common view that equities are a hedge against inflation.

“It is often claimed that equities are a hedge against inflation. But we found this is incorrect. Equities performed especially well in real terms when inflation was low, but high inflation impaired performance and deflation led to lower returns than on government bonds. The correlation between real equity returns and inflation was negative, i.e. equities were a poor hedge against inflation.”

On bonds, they add: “For bonds, the impact is clear. Conventional fixed-income bonds have cash flows that are contractually fixed in nominal terms. When inflation rises, interest rates will also tend to rise. Fixed-income securities thus have unchanged cash flows, but these will be discounted at a higher rate. Their prices will fall.”

Are shares really a bad inflation hedge?

While looking at the short-term performance of shares when inflation spikes shows a negative correlation with rising prices, over longer periods equities have proven a successful defence against rising prices.

Companies that grow earnings and dividends above the inflation rate are touted as a strong inflation hedge by Nick Train, manager of the Super 60-rated Lindsell Train UK Equity fund.

He gives the example of alcoholic drinks giant Diageo (LSE:DGE). In a January update to investors, he said: “It is an ideal investment to hold in current economic conditions because it offers a rare and valuable combination of inflation protection and secular growth.”

Train says those qualities were on display in the interim results that Diageo reported at the end of January, with organic sales growth of 9% driving an earnings gain of 15%, with more of the same predicted for the second half of the year and beyond. The interim dividend was hiked 5%, meaning it has grown every year since Diageo was created a quarter of a century ago, according to Train.

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“Companies that can increase their dividends every year for 25 years are indeed rare and valuable,” he said.

Will Mcintosh-Whyte, a multi-asset portfolio manager at Rathbones, also says looking for high-quality companies with unique businesses are a good inflation hedge.

He says firms such as ASML and Cadence, which are vital parts of the semiconductor industry, could make good investments, as well as companies with strong brands that could actually gain market share during difficult economic times, such as McDonald’s or Costco.