The scepter of inflation is haunting the land. It remains to be seen whether it’s only Casper the Ghost, good for scaring small children, or whether we’re dealing with a full blown Poltergeist. We will have our answer soon enough. But it’s not too early to ask ourselves what should we do if relevant authorities fail to exorcise the demon. Especially because they don’t seem to be trying that hard.

It has been forty years since the last bout of uncontrolled inflation in the US. Most people who are now active in the financial markets have no first hand experience of inflation and how to deal with it. It’s hard to get solid advice; history must be our guide.

A new paper by a team of researchers at Man Group, together with Campbell Harvey of Duke University, looked at the historical data from past inflationary periods. Over the last 95 years, the US spent about 20% of time in conditions of high inflation, defined as sustained periods of 5% or higher inflation lasting at least 6 months. The remaining 80% of time were classified as periods of low inflation.

The research examined the performance of various asset classes and strategies under different conditions. Performance was defined as annualized real returns. I summarized the most interesting findings in the following table:

Asset/Strategy Inflation No inflation
Trend following - all assets 25% 15%
Trend following - commodities 20% 8%
Commodities - buy and hold 14% 1%
Gold 13% 1%
TIPS 2% 3%
Residential real estate -2% 2%
Treasuries - 2 year -3% 2%
Equities -7% 10%
Corporate bonds -7% 6%
Treasuries - 30 year -8% 5%

Neither equities nor bonds had performed well during inflationary periods. No individual equity sector offered unusual protection (for example, energy sector performed just as poorly as others). Treasury inflation-protected securities (TIPS) delivered the only positive returns among the traditional asset classes.

Commodities performed well during inflationary periods, but the clear winner was trend following on a portfolio of all assets, including commodities, equities, and bonds. The trend following strategy used in the article was a simple academic one based on monthly data and excluding execution costs or capacity constraints.

Most investors believe that stocks will preserve their value if inflation goes up. The historical record shows the opposite: stocks suffer just as much from inflation as bonds. There are many possible explanations. The research team highlighted a few: shrinking profit margins as companies cannot fully pass on their increased costs; rise in effective tax rates as historical depreciation underestimates true depreciation; increased cost of capital necessary to offset high nominal interest rates. No matter which one is correct (and there may be multiple causes), the verdict is unambiguous: investment in stocks does not protect investors from high inflation. The only reliable inflation hedge is commodity investing, preferrably with a trend following strategy.