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CASH AS AN INFLATION HEDGE: REVISITED

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The Wealth Advisor Contributor
June 27, 2022

(Morningstar) - The Original Argument

Two summers ago, I suggested that cash might protect portfolios against
inflation. The article was theoretical, prices having long been stagnant, but
economic conditions do change. Besides, several readers had expressed their
concern that inflation would resurface when the economy recovered. Correct they
were.

My claim was as follows: The United States had suffered three inflationary
periods during the previous century. The first occurred during and after World
War II. Cash—meaning Treasury bills or other short high-quality debt, rather
than currency stuffed under a mattress—performed disastrously because the
Federal Reserve steadfastly kept short-term interest rates near zero.

That episode demonstrated that high inflation accompanied by low payouts is a
terrible investment. (You probably guessed that already.) The experience was,
however, anomalous. When inflation returned in the mid-’60s, the Fed altered its
tactics by raising short-term rates. Cash was therefore able to record a modest
real gain. (All calculations in today’s column adjust for the effect of
inflation. For further information on the computations, see the End Note.)
Although cash trailed both stocks and intermediate bonds, it at least avoided
long bonds’ fate.

 



When inflation increased further, in the early ‘70s, cash became the relative
star. True, it lost some purchasing power through the period, but it handily
bested stocks and bonds. Better a haircut than a scalping.

 

 




INFLATION RESUMES

Thus ended my August 2020 article. (In 200 words, I have recapitulated what
previously required 1,000. It appears that I have become smarter.) Because
today’s Federal Reserve figures to fight price increases rather than ignore
them, I concluded that cash would likely prove a useful hedge, should inflation
rekindle. That thesis can now be tested.

The first Bureau of Labor Statistics report to ring the inflation bell was
released on May 12, 2021, indicating that the Consumer Price Index had risen by
4.2% over the previous 12 months. My comparisons therefore begin with that week.
They indicate how stocks, long bonds, intermediate bonds, and cash have
performed during the current inflationary cycle. (Foreign equities, regrettably,
have traded much like their American counterparts.)

Another relative success for cash. Once more, it failed to generate a positive
real return, but once again it was the best of the bunch. Setting aside the
peculiar conditions of World War II, which are unlikely (one hopes!) to repeat,
cash has now placed third, first, and first against the conventional competition
during three inflationary bouts, with both victories occurring by large margins.


THE ALTERNATIVES

The question then becomes: What about unconventional assets? I evaluated five
alternatives that might protect against inflation. Four are long-standing
options: 1) inflation-protected bonds; 2) multistrategy funds, which are
publicly available funds that emulate hedge funds; 3) gold, and 4) commodities
(mostly energy). The fifth is a newcomer, bitcoin. Finally, I created a
hypothetic investment that owns equal amounts of the first four assets, called
the Four Alternatives Portfolio.

 





Commodities, in particular energy, have flourished since inflation resumed. Not
only has the commodities index thrashed all investment rivals, but it also
carried the Four Alternatives Portfolio to second place. Then came cash, closely
followed by the remaining three alternatives. As for bitcoin ... sigh. Not that
long ago, many pundits, including this idiot, wondered if cryptocurrencies might
protect against an unanticipated increase in inflation. We wonder no longer.

The Four Alternatives Portfolio would also have outdone cash when inflation
attacked in the ‘70s. True, neither inflation-protected bonds nor public
versions of hedge funds had yet been invented, so the portfolio could not have
existed in that form. Replace those investments with pretty much anything,
however, and the Four Alternatives would yet have thrived, thanks to huge gains
from its gold and energy positions.

The sample size is small but the pattern strong. When inflation has exceeded
predictions, commodities have prospered. It therefore seems probable that if
high inflation lingers—a condition that would indeed defy government forecasts,
as the Congressional Budget Office projects next year’s U.S. inflation rate to
be 3.1%—the Four Alternatives Portfolio will continue to succeed. In such a
climate, cash should perform respectably, particularly as rising rates create
higher payouts, but it would likely trail alternative portfolios that contain
commodities.


THE DANGER ZONE

So far, alternative investments seem superior to cash. However, things are not
so simple. The Four Alternatives Portfolio has only been better when inflation
persists—and frequently, it has not. In 1987, it sounded a false alarm by
abruptly tripling, only to recede. History repeated from spring 2007 to 2008,
when both inflation and oil prices surged, before heading back to whence they
had come.

I cannot compute what the Four Alternatives Portfolio would have returned when
stocks crashed in late 1987, due to a lack of data, but I can illustrate how
that investment would have performed through the 2008 financial crisis, as well
as during the brief but painful coronavirus lockdown of 2020: not well. Not well
at all.




PARTING WORDS

To summarize:

1) If inflation persists, alternatives will likely lead the way, followed by
cash and/or stocks, with intermediate bonds being somewhat weaker and long bonds
worse yet. (About bitcoin’s fate, I will not speculate.)

2) If inflation subsides and employment remains healthy, stocks and bonds should
rebound, with alternatives and cash lagging.

3) If inflation subsides and a recession lurks, bonds will be the safest refuge,
with cash close behind. Further back will be alternatives, and then stocks.

For me, cash is a more appealing inflation hedge than commodities. Although cash
will not match the alternatives’ performance if the first scenario transpires,
neither does it face the possibility of cratering should a recession loom. That
said, alternatives are the sounder choice for investors who fully, truly believe
that inflation is here to stay.


END NOTE

This column’s first three exhibits were created by data from several Ibbotson
Associates indexes: 1) Large Stocks, 2) 30-Day Treasury Bills, 3)
Intermediate-Term Government Bonds, 4) Long-Term Government Bonds, and 5)
Inflation.

The final two exhibits use: 1) Morningstar 1-3 Month Treasury Bill Index, 2)
Consumer Price Index data, and, as proxies for market returns, 3) Vanguard Total
Stock Market VTSAX, 4) Vanguard Long-Term Treasury Index VLGSX, 5) Vanguard
Intermediate-Term Treasury VFIUX, 6) Vanguard Inflation-Protected
Securities VAIPX, 7) iShares S&P GSCI Commodity-Linked Indexed Trust GSG, 8)
SPDR Gold Shares GLD, and 9) United States Oil USO. Finally, the exhibits use
the 10) Multistrategy Fund Category average.

Whew.

By John Rekenthaler
June 23, 2022


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