Nothing Can Hedge Against Inflation

We have already discussed how and why inflation is bad for you, investment-wise. All returns should only be considered after inflation has been factored in: it’s the real return that matters, not nominal.

 Although it’s the general level of inflation that is talked/tweeted/worried about, it’s actually specific inflation that’s the problem (I don’t care about petrol prices rising if I don’t drive). It’s best to try and counter this specific problem with a specific solution; real inflation protection is about hedging future consumption. Your specific future consumption.

The problem is that this is easier said than done. How do I hedge against the rent on my dingy 7th floor flat in South London rising exponentially? I could purchase some type of retail-focused, London-focused, “up-and-coming”-focused REIT but this doesn’t give me much protection against micro-area-specific demand-supply imbalances that inevitably lead to price movements in the upward direction.

So, alas, I find myself giving general inflation-protecting assets second consideration. I have already discussed why these assets may shield against the corrosive influence of inflation on returns but I thought I’d take a look at if they actually do; if they would have provided protection in the past, to what extent, and how precisely.

Let’s look at the data

My rigorous method of deciding which assets to assess involved recalling which assets I had seen quoted as being a “hedge against inflation”:

• The stock market
• Owning property
• Oil
• Gold
• Cryptocurrency

Wouldn’t it be just lovely if one or more of these assets would increase each month with the general level of prices? Your expenses would tick up slightly each month but don’t worry – your assets have grown in value too.

As we can see here, house prices and the general level of prices seem to be moving in tandem directionally. General prices continue to rise in a slow, monotonous, inevitable fashion (in recent history) but house prices take you on a bit of a ride.

One could conclude that housing is therefore a reasonable hedge against inflation. But this appearance is largely a mirage, caused by the fact that both have simply been moving up and to the left since the start of our sample period. This is the problem with this type of analysis in general – any asset that has been increasing in price over the last X number of years will appear to be a hedge against inflation because prices have been rising essentially since we started recording prices.

When we start to look at the actual numbers we see that all these assets are not fit for purpose. The correlation between inflation and returns is slightly better than what you might find between inflation and noise:

	HPI	FTSE 100	Gold	Oil	Bitcoin	Ethereum	Noise
Data Start Year	2005	2001	1979	1987	2014	2017	2005
Correlation	0.15	-0.07	0.02	0.16	0.17	0.11	0.08
% Changes Greater Than Inflation Rate	60	56	49	53	61	63	45
% Changes Same Direction As Inflation	59	49	52	56	50	47	49

As you can see most do not offer consistent protection on a monthly basis. 

WE NEED MORE DATA

“But Haydn,” I hear you cry “this analysis is unfair. Firstly – it would be unreasonable to expect an asset to track inflation on a monthly basis. Secondly – we don’t care; we just want something that will hedge against inflation in the long-run.”

Fine – let’s look at annual data and extend the timeline.

Again, it looks like house prices might be a good hedge. Again, the numbers say otherwise:

	House Prices	Share Prices	Gold	Oil	Noise
Data Start Year	1953	1800	1979	1987	1800
Correlation	0.17	0.11	-0.02	0.13	0.13
% Greater Than Inflation Rate	61	56	54	50	42
% Same Direction Change As Inflation	87	59	62	53	50

Annual still too short? Let’s look at 5-year buckets:

Why not 20…or 50?

Uncertainty: the inevitable destination

The problem with this type of analysis is that lots of things determine the price of oil, house prices, Ethereum, etc. and lots of things also determine the rate of inflation. So any type of standard statistical analysis just isn’t going to cut the mustard in terms of discovering a relationship between these types of variables.

Low correlation doesn’t mean that we can rule out the presence of causality. But that’s ok – we don’t care about causality. We just want something that hedges against inflation – some price of some thing that moves in the same direction as the price of things that we buy. None of these assets, on a monthly or annual frequency, accomplish this on a consistent basis. Not to any degree we would like, anyway.

Whether this is true over longer periods of time is more unclear. Extending our data back hundreds of years might reveal that assets we thought were a “sure thing” in terms of countering inflation may not actually be that certain. And of course, we run into the age-old problem of induction mentioned too many times on this blog.