With a total U.S. inflation rate of 14% in the past two years, we review how various inflation hedges performed over the past twenty-four months.
Topics covered include:
- What were investors’ and the Federal Reserve’s inflation expectations two years ago
- What led to the big inflation increase
- Why was the Federal Reserve forced to raise its policy rate by almost 5% in a year
- How successful were inflation-index bonds, stocks, commodities, and real estate in beating inflation over the past two years
- How did two active ETFs that set out to protect against inflation perform
- What is the current outlook for inflation, and what should investors do
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iShares TIPS Bond ETF (TIP)
Vanguard Short-term Inflation Protection Securities ETF (VTIP)
Invesco DB Commodity Index Tracking Fund (DBC)
Vanguard Total World Stock ETF (VT)
Vanguard Total Stock Market ETF (VTI)
WisdomTree U.S. High Dividend Fund (DHS)
WisdomTree Global High Dividend Fund (DEW)
Horizon Kinetics Inflation Beneficiaries ETF (INFL)
Schwab U.S. REIT ETF (SCHH)
Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today is episode 429. It’s titled “Which Inflation Hedges Worked, and Which Didn’t?”
Two years ago, in the spring of 2021, we released a number of episodes on the risk of higher inflation, and on investments that could help protect against inflation.
An investment protects against inflation if it generates a return greater than inflation. In this episode, we want to review how those inflation-hedging strategies actually worked. Did they outperform the inflation rate, allowing investors to maintain the purchasing power of their assets?
Current and Expected Inflation
First, what has been the inflation rate? I use the CPI Inflation Calculator provided by the Bureau of Labor Statistics; it’s based on the consumer price index for All Urban Consumers, known as CPIU. That reflects the average price in US cities for hundreds of goods and services that are purchased for consumption by households.
That inflation calculator, $100 in March 2021 has the same buying power as $113.95 in March 2023, that means inflation has increased just about 14% on a total or cumulative basis. For an investment to have outpaced inflation over the past two years, it needs to have a cumulative return, a total return of over 14%.
Two years ago, the financial markets, they weren’t pricing in high inflation.
If we looked at the five-year inflation rate as reflected in inflation protection securities, those TIPS were priced assuming an inflation rate of two and a half percent per year for the next five years. Now, again, that was two years ago, we’ve had inflation of 14% over the past two years.
In order to get a five-year average inflation rate of two and a half percent when you’ve had 14% in the first two years you basically need prices to not increase at all; actually, even fall a little bit in order to meet that, and that’s just not going to happen, right? It could. Not likely.
If we look at current expectations for inflation, looking out five years, as reflected in TIPS prices, they’re priced at a 2.4% annual inflation rate over the next five years.
Now, we don’t actually have the two-year expected inflation rate from two years ago. The US Treasury provides real rates, which we can compare to nominal rates to figure out what that embedded inflation rate is.
Federal Reserve Open Market Committee
So we can look at what the current real rate is of, let’s say, five-year TIPS; they are around 1.2%. And then we can look at the five-year nominal yield, which is around 3.6%, and that difference is 2.4%, or what’s known as the breakeven inflation rate. Suffice to say, we know that two-year inflation expectations two years ago were not for the 6% to 7% inflation rate we’ve seen. What we do know, though, is what the Federal Reserve Open Market Committee was expecting inflation to be two years ago.
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