Is there such thing as an inflation hedge asset
Is There Such Thing as an Inflation Hedge Asset ?
A Logical Consideration
Conventional class room economic theory teaches that in periods of rising inflation and interest rates, bond prices will fall and stock prices will rise. Rising inflation makes investments in bonds less attractive and investments in stocks or real estate more attractive. Stocks and real estate are inflation hedge assets. Is this a valid or at least logical conclusion ?
Rising inflation is usually accompanied by rising interest rates. Infact the determination of interest rates as argued by Irving Fisher in his model explicitly uses inflation as a variable affecting the expected nominal interest rate.
Expected Expected Expected
Nominal = Real + Inflation + Real X Inflation
Interest Rate Rate Premium Rate Premium
The expected nominal interest rate will eventually affect bond prices and returns since bond prices are determined by calculating the present value of all future coupon payments and repayment of bond principal. The present value of these cash flows are calculated by dividing them by a discount factor that takes into account the percentage return required by investors which is usually reflected in the prevailing interest rate
So in a period of rising inflation, as the Irving Fisher model suggests, interest rates are also expected to rise. And since interest rate is explicitly entered as a variable in the determination of bond prices, rising inflation will cause a rise in interest rates which will reduce the calculated present value of the fixed nominal bond coupon payments and repayment of bond principal hence reducing the real returns to the bond investor. But why should this make investments in stocks or real estate more attractive ? Do stocks and real estate actually make for good inflation hedge assets ?
Rising inflation and interest rates means higher cost of funds for people who need loans. The purchase of real estate is usually a large purchase that requires debt financing. With a higher interest rate the cost of purchasing real estate will rise. Real estate investors hope to profit from rent income and / or from capital gains if they sell the property. In inflationary periods the real value of the money owners receive from tenants may be partially reduced by inflation while maintenance costs may rise, squeezing profit margins and these cost increases may not be easily passed on to consumers. Capital gain which is calculated by subtracting the purchase cost of the property from the sale price received is also eroded by rising interest rates and inflation since they increase the debt-financed purchase cost of real estate and by reducing the value of future sale revenue that the investor eventually receives. Inflation also eats away at the real income and purchasing power of all potential buyers hence reducing the possible price at which the investor can expect to sell thus further decreasing the profit potential of real estate investments.
Investment in stock is also negatively affected by rising inflation and interest rates since rising inflation means rising interest expense and other business costs such as labor, material and / or equipment expenses that eat away at company profits. Some might argue that inflation, which by definition is a rise in the general price level will improve company profit by causing the price of products that the company produces to rise basic laws of supply and demand dictates that an increase in price may lead to lower demand.
Even if an investor is able to invest in real estate or run a business without debt financing they are using their own funds at an opportunity cost equaling the return they could receive from interest bearing securities such as bonds. So a logical conclusion that this article arrives at is that in general stocks and real estate are not inflation hedge assets. The above discussion has not shown any reason why in periods of inflation investments in bonds in general should become comparably less attractive and investments in stock or real estate in general should become comparably more attractive.
Since the topic of bonds, stocks and real estate have been covered, this discussion can be extended to cover other asset classes such as gold and commodities.
Gold is a curious case for discussion since unlike the other assets mentioned above, gold derives its value from its inherent scarcity. It does not pay out interest, coupons, rent or dividends and it also has almost no functional utility or practical purpose except as raw material for jewelry which is difficult to measure since its value would be judged on aesthetics which is inherently subjective. In the past gold may have had a certain immunity against inflation, but this quality was not inherent to the nature of the precious metal itself but rather it was due to the decision of man and state in pegging their currency to gold. And since the practice of pegging currency to gold has largely been eliminated then there should be no reason why gold should serve as an inflation hedge asset.
Natural resources on the other hand are usually commodities that have high utility. Wheat and corn for example are critical in providing nutrition. Given how highly needed these commodities are, they should generally have a very low price elasticity of demand, meaning a large increase in the price of these commodities will have only a small effect on the demand for them. Therefore any cost increases in the production of these commodities should be easily transferrable to the buyers through a higher sales price, but the extent to which producers can pass on their inflation-caused rise in costs is limited by supply from competing producers. Commodities are practically identical so the products of one producer is essentially the same as products of another producer. And since they have a low price elasticity of demand, even if a large decrease in prices were to occur demand would increase only marginally. Producers cannot make up for slim margins with high volume. It should also be acknowledged that when investments in commodities are under discussion it is in reference to investments in derivative products such as futures commodities contracts, but since these products by definition derive their value from the underlying commodity the end result should be the same. Inflation affects commodities negatively therefore investments in commodities in general is not an inflation hedge asset.
In the search for an inflation hedge asset this article does manage to find a tiny spark of light at the end of the tunnel once the subject of one particular commodity is considered. Oil.
Oil is a non-renewable natural resource and given the lack of alternative energy, it is the main source of energy for the entire world. This particular business requires very large amounts of capital hence competition is effectively limited. But where large amounts of capital is needed some debt financing is usually required and as mentioned before debt interest is an expense that eats away at profits. However given the low price elasticity of demand for oil any increase in expenses can be passed on to the consumers.
After reviewing the above discussion it might actually be possible to find an investment that stands against the test of inflation. But achieving the goal of inflation hedging is not done by simply switching asset classes, rather by finding certain qualities in a particular asset. The qualities displayed by oil which are low price elasticity of demand, high utility, limited competition, limited substitution and limited supply in combination are qualities that should be focused on in searching for inflation hedge assets. These characteristics together seem to be characteristics that can potentially produce superior returns when present in a particular product, company or commodity.
About the Author
Author holds a bachelor degree in economics from universitas Airlangga in Surabaya Indonesia and is currently studying towards a graduate degree in accounting at universitas Triskti in Jakarta Indonesia
A Message from Al Franken