Investors are eagerly looking for the perfect inflation hedge

Autor: Article based upon analysis from Reuters Breakingviews | Link: The urgent search for the perfect inflation hedge
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Index-linked bonds are protecting investors from rising prices. At least they should be. Everything else – equities, stocks and bonds, gold, industrial commodities, real estate – although having their particular attractions, count for more risks and shortcomings. But is it so?

Gold has appreciated by around 1,400% during the decade of the Great Inflation, moving inversely with the stock market.

The unappealing side is the fact that the precious metal doesn’t generate income and is difficult to value. Also, gold has proved to be a source of economic bubbles when paper assets dropped and collapsed in value.

Equities, which are claims on real assets, protect against inflation over the long run. But in shorter time frames stock market valuations tend to decline as bond yields rise.

Between 1966 and 1981, when inflation last took off, the ratio of price to earnings of U.S. equities halved.

For the past couple of decades, bonds and stocks moved in opposite directions over short periods.

That’s why conventional investment portfolios benefited from that. When the stock market declined, long-term interest rates would fall, thereby boosting bond prices.

Fabulous returns were delivered in the benchmark investment portfolio with 60% allocated to equities and a 40% weighting in bonds.

Inflation though, especially when it takes off, creates a positive correlation between stocks and bonds.

They rise and fall together. In this year’s first half, a classic 60-40 portfolio in the UK declined 16% in nominal terms.

The failure of bonds and stocks to deliver protection when inflation spikes have forced investors to look also at property.

But U.S. real estate investment trusts were down 19% in the first six months of the year. The value of bricks and mortar doesn’t always increase in line with prices.

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These days, inflation is making a mess on the markets and in invested wealth.

Except for commodities, all major asset classes – ranging from U.S. leveraged loans to emerging market equities – have lost money so far this year.

Investors are looking once again for options. Inflation-protected gilts have their interest and principal linked to an index of prices and were introduced by the UK government in 1981.

In the U.S. Treasury Inflation-Protected Securities (TIPs) were firstly offered in 1997.

They have a good track record, but this year these bonds have proved one of the worst inflation hedges.

The biggest losses were counted for 10-year TIPs that are down more than 10% so far, and for some long-dated UK index-linked gilts that have crashed.

So another myth seems to have been broken. But there’s a catch.

These bonds were at minus 1% in January and now are at 1.6%, roughly in line with recent growth in U.S. productivity – a loose proxy for the TIPs fair value.

Extreme overvaluation is the reason for the losses, not the structure.

By contrast, the real yield on conventional 10-year Treasuries is currently minus 4%.

Investors expect inflation will average 2.5% over the next decade, only a little above the Federal Reserve’s target.

Prudent investors should replace their conventional Treasuries with TIPs.

A decent real yield and protection against unexpected inflation should help them sleep easier at night.