The Imperfect Hedge, Without Wax
For those who haven’t yet read about the origin behind our company name, SineCera, it is derived from the Latin phrase sine (“without”) cera (“wax”). In ancient Greece and Rome, dishonest sculptors would melt wax into the marble to conceal chips or cracks in their work. Thus, honest sculptors presenting their work would say their sculpture was “sine cera” or “without wax.” At SineCera, our due diligence is continuously trying to discover cracks in our portfolio construction. Nowhere has that been truer than in building the inflation-hedging component for our All-Weather strategy. We believe that our clients deserve transparent investment guidance and so this post will discuss our inflation-hedging solution – without wax.
Inflation-hedging assets are the third component of our All-Weather portfolio, a strategy which equally distributes risk across three investment categories (the other two being equities and bonds). The goal is to capture the risk premiums, or returns over the risk-free rate, that are generated by these assets over time. While the return profile of equities is somewhat straightforward (stockholders, in general, are rewarded in periods of economic growth), and we have written about our views on bonds before, it’s harder to conceptualize an inflation risk premium. Further, there are disparate views on what the best inflation-beating assets are.
Unfortunately, it’s not possible to capture pure exposure to the inflation-hedging premium. There’s significant disparity in investments capable of generating excess return during inflationary periods. Whether it’s gold, commodity futures, commodity-related equities, real estate, floating-rate bonds, TIPS, etc. each performs differently depending on the type of inflation (unexpected vs expected inflation), and its underlying source. While we’ve reviewed these alternatives at length (and are happy to discuss our findings with you), I’d like to focus on the two we’ve chosen as the foundation to our inflation-hedging portfolio: gold and commodity-related equities.
Why Gold?
“In 5,000 years of human history, gold has been the currency of choice, the store of value when humans have called into question their governments’ effort to solve problems by running printing presses and injecting money into the economy.”
Inflation, put simply, is an increase in the price of goods and/or services. “Price inflation” can be driven by two factors: user demand can grow faster than supply (demand-pull inflation), or the underlying costs of production (raw materials, wages and other inputs) can rise due to limited supply (cost-push inflation). Inflation can also be exacerbated by loose monetary policy (i.e. the government increasing money supply to boost demand). Over the past decade-plus, loose monetary policy has resulted in significant asset-price inflation (see returns on risk asset over the past ten years, 2020 notwithstanding). All else equal, as prices increase, the value of the purchasing currency depreciates—$1 would not buy as much as it did pre-inflation. In periods of unexpected inflation, where interest rates do not keep up with the rate of inflation, currency devaluation can be especially pronounced. When building our inflation-hedging portfolio, it’s these periods of unexpected inflation and currency devaluation that we care most about.
Gold serves us well in two key aspects: hedging against currency devaluation and diversification. For millennia, gold has been coveted as a store of value, and has functioned as a “safe haven” asset during periods of currency devaluation. Gold performed particularly well in the 1970s, when real yields (nominal interest rates minus inflation) went negative; when real yields are low it means the opportunity cost to owning gold is low and it’s relatively cheap to own. With interest rates around the world being held at or near zero, real yields are almost entirely driven by changes in inflation. And as long as nominal rates stay low, gold’s correlation to changes in inflation becomes more pronounced.
Gold also has a significantly lower correlation to equities than broad-based commodity exposure, as shown in the chart below. This helps us maintain a more meaningful allocation to our inflation-hedging assets without increasing correlation to the stock market performance
Why Commodity-Related Equities?
“It should also be noted that commodity-related equities are more significantly exposed to equity market movements than to commodities. This means that these equities provide less diversification benefits than commodities…However…unlike commodities, equities are cashflow generating assets and despite having slightly lower short-term inflation beta, they are more likely to provide higher returns over the longer term.”
Though commodity futures provide strong inflation-hedging and diversification benefits, we prefer allocating to stocks in the energy and basic materials sectors. With respect to commodity futures, history has shown that average excess returns are trivial (Erb, Harvey, 2014), meaning these investments typically do not provide a return premium above the risk-free rate. Further, when it comes to inflation-hedging, all commodities are not created equal. This makes the commonly pursued broad-based, passive approach unappealing. As for active management, Alpha generation is incredibly hard to come by, especially when accounting for high fees and trading costs. Thus, when combining long-term return potential and inflation-hedging capability, we prefer going the commodity-related equity route. Certainly, lots of research focuses on the oil-induced inflation shocks of the 1970s as the main example of commodity-related equities doing extremely well in a rapid inflationary environment. But, as key components of the global supply chain, oil and other basic raw materials are fundamentally tied to price inflation, which is why we like these assets. When researching which equity sectors had high inflation betas (a measure of the relationship between investment return and changes in inflation), energy and basic materials companies stood out.[i][ii][iii]
Our goal with the All-Weather strategy is to build a durable portfolio that can withstand multiple market environments—periods that may not resemble anything we’ve seen in the last few decades. Like many Roman stone archways that still stand today, while the individual blocks may not appear stable, when built right they collectively provide a durable, long-lasting platform. To some, our inflation-hedging assets may not seem like the right fit when evaluated as standalone assets. But, as components of a complete, all-weather portfolio, we believe they provide the right counterbalance to our equity and fixed income exposures.
As always, if you have any questions, please do not hesitate to contact us.
Best Regards,
Adam J. Packer, CFA®
Chief Analyst | SineCera Capital
Disclaimer: The information provided is for educational purposes only. The views expressed here are those of the author and may not represent the views of SineCera Capital. Neither SineCera Capital nor the author makes any warranty or representation as to the accuracy, completeness or reliability of this information. Please be advised that this content may contain errors, is subject to revision at all times, and should not be relied upon for any purpose. Under no circumstances shall SineCera Capital be liable to you or anyone else for damage stemming from the use or misuse of this information.
[i] What are the inflation beating asset classes? Schroder Investment Management, Schroders Multi-Asset Team, January 2014
[ii] Equity Investments as a Hedge against Inflation, Lazard Asset Management, September 2017
[iii] Deflating Inflation | Redefining the Inflation-Resistant Portfolio, AllianceBernstein, April 2010