4. What really protected against inflation and what did not

Macro 4: Inflation, currencies and commodities

This module closes the level with the question most often asked and most poorly answered. The honest answer is uncomfortable: almost everything sold as an inflation hedge protects badly, late, or only over horizons that do not match those of the person buying it.

The distinction that orders everything: expected versus unexpected

If the market is pricing 2.5% inflation for the coming decade, that 2.5% is already built into the yield on the nominal bond, into company accounts and into the price of everything else. Expected inflation does not make you poorer: you are paid for it.

What destroys portfolios is the surprise. Hedging against inflation therefore does not mean buying assets that rise when prices rise, but assets that rise when expected inflation is revised upwards. And the second axis is the horizon: an asset can be an excellent hedge over twenty years and utterly useless over two, which is precisely the horizon over which most people need the money.

Gold: a poor hedge in the short run, erratic in the long

The case for gold almost always rests on the same decade. Between 1971 and January 1980 it went from 35 dollars an ounce to around 850, while US inflation ran out of control. Impeccable.

What is almost never told is what came next. From that peak, gold fell for twenty years to around 250-300 dollars, and although in nominal terms it recovered its 1980 level in 2008, in real terms it took more than four decades even to come close to that peak. A saver who bought gold at the 1980 top to protect against inflation lost purchasing power across an entire working life.

Erb and Harvey formalized it: the relationship between the price of gold and the price index oscillates around a mean, and when gold is expensive relative to CPI, subsequent real returns have been poor. It is not a stable store of value over ten years: it is a highly volatile asset whose real return over the very long run tends toward zero and whose correlation with annual inflation surprises is close to nil.

Equities: they protect over the long run and fail exactly when the blow lands

Equities have a solid structural argument in their favor: profits are nominal quantities. If everything rises in price, sales rise, costs rise and profit ends up rising too. Over thirty years, equities have beaten inflation comfortably in practically every developed market.

The problem is the journey. When an inflation surprise arrives, three things happen at once: the discount rate rises, the risk premium rises because uncertainty increases, and margins compress because costs are passed through before selling prices are. The multiple contracts. You already saw in Level 1 what 1966-1982 looked like, and in 2022 the S&P 500 fell around 18% including dividends, in the worst year for inflation in four decades.

Translated: equities are a hedge for the saver with twenty years ahead and a trap for anyone who needs the money in three.

Inflation-linked bonds: the direct hedge and its small print

They are the only instrument designed explicitly for this. The principal is adjusted by the price index and the coupon is paid on that adjusted principal, so what you lock in when you buy is not a nominal yield but a real yield. If you hold to maturity, you earn that real yield whatever happens to CPI. That is a genuinely clean hedge.

But it comes with two limitations that are almost never explained:

• You pay the breakeven. If the market is pricing 3%, you only gain against the nominal bond if inflation exceeds 3%. You buy protection at the price the consensus already quotes.
• The price moves with the real yield. An inflation-linked bond has duration, and if the real yield rises its price falls even with inflation running hot. In 2022 the US index of these bonds lost close to 12%, because the ten-year real yield went from roughly minus 1% to plus 1.5%. It protected against inflation, not against rising real yields. Short maturities are the closest thing to a pure hedge.

Commodities: the only thing that worked, with a bill payable later

In 2022 the Bloomberg commodity index rose around 16%, in a year when everything else was falling. That is no accident: energy and food sit literally inside the price index, so a cost shock is inflation, not an asset correlated with it.

The bill arrives afterwards. The expected long-run real return on a diversified basket of futures is low, its volatility frequently exceeds 20% a year and it strings together decade-long spells in the wilderness, such as the one running from 2011 to 2020. Erb and Harvey showed that the average individual future has barely delivered a positive real return, and that what little it did contribute came from rebalancing the basket and from interest on the collateral. That makes them what they are: insurance paid for year after year and claimed on the day of the fire. You size it like a policy, not like the engine of the portfolio.

The real scoreboard of 2021-2022

With US CPI closing 2022 at around 6.5%, this is how the picture looked in real terms:

• Commodities: clearly positive, the only winners.
• Gold: roughly flat in dollars, that is, a real loss of several points in the very year that supposedly justified owning it.
• Inflation-linked bonds: around minus 12% in nominal terms, sunk by the real yield.
• Equities: around minus 18%, more than 20% in real terms.
• Long-dated government debt: its worst year on record.

The only thing that protected was the asset with the lowest expected long-run return. That is no anomaly: it is the price of insurance, collected in advance during all the years you did not need it.