As with many situations there is a trade-off - what works very well as protection often has low returns. Let's therefore have a look at the major asset classes to see how they respond to unexpected inflation.
Expected vs Unexpected Inflation - First, it's necessary to clarify that what's expected won't hurt so much, it's the unexpected that matters. With inflation running at around 2%, the expected returns and yields of various investments have that amount (as we noted in this recent post) incorporated into prices. It's the shock and surprise increases that take away real value which hurt investors.
Macro-Economic Volatility and Supply Shock Inflation vs "Great Moderation" Inflation - It probably has not seemed so to those suffering through rising prices, but the nature of inflation has differed in the 1990s and 2000s from the decades of the 1970s and 80s. The less volatile business cycles of more recent times, termed the Great Moderation, have entailed a different kind of inflation. In the 1970s, inflation arose more from supply shocks, in the form of big oil price increases, and at times when the economy struggled, while in the more recent period inflation has risen in tandem with good economic growth. That, according to the research paper Inflation-Hedging Portfolios: Economic Regimes Matter (on SSRN) by Marie Grière and Ombretta Signori, has meant that the best protection against inflation has changed, as we note below.
Short-term vs Long Term - The final key distinction is that the type of investment that responds well and quickly to a surprise inflation leap may not do as well as another over many years.
Asset Classes - How they respond to inflation
a) Cash - Except for a short few months of typical lag before rates adjust, cash investments like T-Bills and money-market funds will rise with inflation, no matter what the economic regime. The bad news is the trade-off that returns on cash short- and long-term are low and, as Brière and Signori point out, the return on a long-term investment in cash stands a fair risk of falling shy of full inflation-matching. BlackRock's review Are Hedging Properties Inflated? notes how central bank policies like ones in place at present may mean negative overall real returns for cash.
b) Nominal Bonds (Government 10+ year) - Bonds do not usually offer inflation protection. On the contrary, in the short term bonds suffer losses through price reductions. However, with longer holding periods extending out more and more years, bonds progressively recover. During the years of the Great Moderation, Grière and Sognori even found nominal bonds to be a good long-run inflation hedge, whereas in the earlier opposite economic environment, nominal bonds were a bad choice for inflation compensation. This brings to the fore a key issue for investors - will the Bank of Canada (and other central banks) continue to maintain their credibility and the belief of investors that inflation will not be allowed to run rampant? If inflation is consistently contained, nominal bonds will do fine as inflation protection. The advantage of nominal bonds over inflation-indexed bonds of similar duration is slightly higher yields.
c) Inflation-Indexed (Real Return) Bonds - Such bonds, called Real Return Bonds in Canada and TIPS in the USA, offer explicit inflation hedging by the built-in mechanism to increase interest and principal in lockstep with a measure of inflation, in Canada that being the CPI. Any and every inflation rise, whether expected or unexpected, feeds automatically into the bonds' returns three months after the actual CPI results. The downside is that net real returns after taking away the inflation-matching portion are very low.
d) Equities (Broad market cap-weight index) - Equities are hurt by unexpected inflation in the short term and especially so when inflation is of the supply shock variety, as the 1970s oil price shocks so well demonstrated when stocks had negative total returns while CPI rose significantly (e.g. see this chart of the USA's S&P 500 index). In the long term, the ability of businesses to cope with inflation by passing through price increases to make up for inflation has enabled gradual, though sometimes not full recovery depending on the period as BlackRock show. The Credit Suisse Global Investment Returns Yearbook for 2012, which examined the inflation-fighting performance of various asset classes, summarized equities as "not particularly good inflation hedges". On the other hand, equities offer the best long-term historical returns record.
e) Real Estate - This asset class is a very poor short-term inflation hedge but an effective long term hedge (see all our reference studies linked in this post), with returns similar to equities.
f) Gold and Precious Metals - In the short-term, gold has been found to be a very good hedge for unexpected inflation but only erratically in certain periods, and is a weak hedge for overall inflation in the long term. It is an asset that produces no income and its long term return from capital appreciation only is very low as the Credit Suisse Yearbook data shows. It's hedging value is probably more related to financial and currency collapse than inflation.
g) Commodities - There appears to be consensus that commodities offer excellent short-run inflation hedging according to an IMF paper of 2011 Inflation Hedging for Long Term Investors by Alexander Attié and Shaun Roache. BlackRock ranks commodities as the best short-term inflation hedge of all the asset types. This conclusion applies to broad commodity indices as individual commodities are not effective. The protection offered by commodities erodes over time till at more than five years, there is no benefit. Worst for the long term, commodities have exhibited negative real returns far short of inflation as the graph below copied from the Attié and Roache paper shows where the dark black line of commodities lies below CPI inflation.
(click to enlarge image)
Given 1) the variable hedging performance of the various asset classes, 2) the difficulties in knowing when inflation surprises are set to arrive (no kidding!) and what type of economic regime and inflation drivers there will be and 3) the need to gain higher returns than simply keep up with inflation, the sensible thing to do for the investor with a long time horizon would seem to us to include some of each asset, to maintain a diversified portfolio that will cope with all the eventualities. Rebalancing to the target asset allocation will take into account the effects of inflation reactions as well as the many other effects affecting asset values such as real interest rates, changing perceptions of riskiness and foreign currency swings.
Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.