Inflation concerns throughout the global economy have increased demand for investment solutions that hedge inflation and store value. In response to this demand, CFA Society Toronto hosted a webinar to discuss hedging inflationary risks on April 4, 2022, presented by James Montier of GMO, a diversified global asset management firm. This article summarizes GMO’s presentation, highlighting inflation drivers, potential hedges, and stores of value.

GMO’s Early Pandemic Inflation Analysis

Source: Montier, James. Everything You Never Wanted to Know About Inflation and Were Afraid to Ask. Presentation, April 4, 2022. GMO. 

GMO’s early pandemic inflation analysis suggested a global aggregate supply shock, resulting in the aggregate supply curve moving from AS_1 to AS_2, combined with a relatively lower reduction in aggregate demand (AD_1 to AD_2) as most countries provided social and business support. As people adapted to the pandemic, aggregate demand increased, resulting in higher prices. The thesis was that the price level increase would not result in long-term rising inflation.

Potential Inflation Drivers

The presenter, Montier, highlighted five potential inflation drivers and shared his opinion of the drivers’ contribution to overall long-term inflation.

1. Money supply

   The money supply rapidly expanded during the pandemic as social and corporate benefits were distributed. The quantity theory of money states that if the amount of money in the economy doubles, all else being equal, prices will double. Although the money supply increased during the pandemic, the increase has since slowed down. The M2 inflation impact is expected to be transitory as a continued reduction in money supply should put downward pressure on inflation. 1

2. Quantitative easing

   Quantitative easing is a monetary policy employed by central banks to purchase securities to reduce interest rates, increase money supply, and drive lending. Historically, when a bout of quantitative easing occurs, reserves surge, more money circulates in the economy, and inflation rises. A shift to quantitative tightening should put downward pressure on inflation.

3. Fiscal deficit

   A fiscal deficit is one component of gross domestic product (GDP), composed of consumption + investment + government spending + net exports. Fiscal deficits do not always drive inflation. For example, in the 1970s, the U.S. experienced a high consumer price index (CPI) with a relatively low deficit. This example underlines that fiscal deficits should not result in prolonged elevated inflation.

4. Spending patterns

   The pandemic shifted spending patterns, leading to a drastic reduction in personal consumption and a recovery in which demand for goods outpaced demand for services. The need for goods alongside pandemic-related production and distribution constraints furthered supply shock inflation. The effect is expected to be transitory as spending patterns and supply chains normalize.

5. Wage-price impact

   The general level of prices in an economy is determined by the level of costs, and the primary influence on costs is the relationship between wages and output, with inflation occurring when wages are greater than productivity. Quit rates have been high, predominately in leisure/hospitality/food services, while unemployment has remained relatively low, emerging from The Great Recession. During the pandemic, wage growth increased among the lowest quartile earners. This segment has a low ability to impact the aggregate demand level and therefore is likely not a core driver of inflation. In addition, there has been a disassociation between productivity and wages since the 1980s: productivity continued to rise while wages stagnated. The gap between productivity and wages provides a cushion against aggregate demand increases, resulting in a wage-price spiral.

   Hedging Inflation

Source: Montier, James. Everything You Never Wanted to Know About Inflation and Were Afraid to Ask. Presentation, April 4, 2022. GMO. 

Investors may purchase Treasury Inflation-Protected Securities (TIPS) or inflation caps as a hedge due to the tight correlation with the underlying risk, but hedges have been expensive. Historically, TIPS have yielded between -50 and -100 basis points (bps), and the price of a ten-year 3 percent inflation cap has been roughly 450 bps.

Storing Value

Commodities as an inflationary storage of value has been a loser in aggregate since the 1950s. Oil has been good storage of value due to the reasonable correlation between oil prices and CPI.

Gold has been regarded as the ultimate storage of value, but it can be challenging to price. Real gold prices are currently at levels consistent with high inflation periods, meaning that accurate gold prices may have already priced in inflation.

Equities are believed to be the best store of value. A corporation straddles wages and prices by paying employees and charging customers fees. This makes equities real assets, as they are reasonably indexed. Resource equities, especially oil stocks, have been strong storers of value and provide an attractive vehicle for combining commodity exposure with a real asset.

Conclusion

Building a robust portfolio focused on storing value could yield a better performance than concentrating solely on hedging inflation. The data from the presentation suggests transitory (non-permanent) inflation will be present until money supply levels normalize, supply and demand for goods return to balance, and supply chain issues are resolved.

1 “M2 is used as an indicator of possible increases or decreases in inflation levels. This is because it is a broader measure of the money supply in an economy than when compared with M1—which only looks at money that is in the hands of the public.” Source: IG. “M2 Money Supply Definition.” Accessed July 22, 2022.