In their latest iteration of the Credit Suisse Global Investment Returns Yearbook 2012, Elroy Dimson, Paul Marsh and Mike Staunton, at the London Business School, note the yawning gap between theory and reality when it comes to inflation expectations.
“As 2012 dawned, inflation-linked bonds issued by Britain, the USA, Canada and several other low-risk sovereigns sold at a real yield that was negative or at best less than 1%. Investors had become so keen on safe-haven securities that they had bid low-risk bonds up to a level at which their real return was close to zero.”
It wasn’t supposed to be that way. Developed market central banks are printing money hand over fist to encourage consumers to spend. Surely that must give rise, if not now, then soon, to inflation. Then again, there’s the long agony of Japan, where despite almost free money, virtually no one is stepping up to the (fashion) plate. Indeed, dollar stores have taken hold in a country that once prized expensive foreign couture.
Of course, inflation is not be toyed with. What a U.S. dollar buys today would have cost 4 cents in 1900. (Cue the hedonic counterarguments here: namely that you get more bang for your buck with consumer electronics, or even just automatic transmissions.)
Dimson et al. note that persistent inflation is mostly a 20th century phenomenon. Apart from the Great Depression, there has been very little deflation, unlike the economic experience of earlier centuries where there was a certain, if unpredictable, alternation between periods of inflation and deflation. That said, with rare exceptions (such as the political straits of Weimar Germany in the 1920s, or among other countries in the aftermath of the Second World War) in most developed markets inflation has actually been quite modest – which of course has not been true of emerging markets. To be sure, there was high inflation in the 1970s, but in the last couple of decades, developed economies have largely tamed inflation.
Against that backdrop, how have various assets performed? History matters. There is a great deal of serial correlation in the data series, such that regimes of inflation or deflation are more likely to continue than be randomly interrupted. Dimson and his colleagues analyze the 19 countries they have in their yearbook for which they have the full 112 years of data.
“[D]uring years in which a country suffered deflation more extreme than -3.5%, the real return on bonds averaged +20.2%. … [L]ast year’s Yearbook, the average real return from bonds varies inversely with contemporaneous inflation. In fact, in the lowest 1% of years in our sample, when deflation was between –26% and ȍ11.8%, bonds provided an average real return of +36%….. Needless to say, in periods of high inflation, real bond returns were particularly poor. As an asset class, bonds suffer in inflation, but they provide a hedge against deflation.”
That shouldn’t be surprising – after all, in any deflationary episode, debtors are on the hook. The problem, arguably, is that investors have been conditioned by the inflation of the 1970s, and expect it to recur. They forget about what happens when prices are repressed.
Thus, “[d]uring marked deflation … (rates of deflation more extreme than –3.5%), equities gave a real return of 11.2%, dramatically underperforming the real return on bonds of 20.2% ….[In non-deflationary or disinflationary periods} equities gave a higher real return than bonds, averaging a premium relative to bonds of more than 5%. During marked inflation, equities gave a real return of -12.0%, dramatically outperforming the bond return of -23.2%.”
A dramatic outperformance, yes, one might argue; but still, a negative real result. And it points to a flaw in collective wisdom about stocks and bonds. Dimson and his colleagues highlight this.
“The distinction is between a high ex-post return and a high ex-ante correlation between nominal returns and inflation. This difference is often misunderstood. For example, it is widely believed that common stocks must be a good hedge against inflation to the extent that they have had long-run returns that were ahead of inflation. But their high ex-post return is better explained as a large equity risk premium. The magnitude of the equity risk premium tells us nothing about the correlation between equity returns and inflation.”
So whither inflation hedging? “[G]old might be proposed as a hedge against inflation, insofar as it is believed to appreciate when inflation is rampant. Yet, … gold has given a far lower long-term return than equities, and for that reason it is unlikely that institutions seeking a worthwhile long-term real return will invest heavily in gold.”
Thus they conclude that, “conventional bonds cannot be a hedge against inflation: they provide a hedge against deflation. Equities, however, being a claim on the real economy, could be portrayed as a hedge against inflation. The hope would be that their nominal, or monetary, return would be higher when consumer prices rise. If equities were to provide a complete hedge against inflation, their real, inflation-adjusted, return would be uncorrelated with consumer prices..However, equities have not behaved like that. When inflation has been moderate and stable, not fluctuating markedly from year to year, equities have performed relatively well. …
“We conclude that while equities may offer limited protection against inflation, they are most influenced by other sources of volatility. Second, bonds have a special role as a hedge against deflation.
Third, commercial real estate has been a somewhat disappointing hedge, inferior to domestic housing.”
Then again, deflated expectations are the best form of risk management.