Reggie Middleton's Take on Investing for Inflation, pt. 3

Friday, 12 June 2009 05:00

Reggie Middleton's Take on Investing for Inflation, pt. 3

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The Performance of Inflation Correlated Assets: Reggie Middleton's Opinion

This is part 3 of my thoughts on investing in inflationary times (see Reggie Middleton's Take on Investing for Inflation, pt. 1 and Reggie Middleton's Take on Investing for Inflation, pt. 2). I had my team run independent verification of inflation correlated asset performance, for it appears to me that many investors tend to simply follow what they have heard other say versus looking into what the facts are. In the process of the investigation, we have tracked the performance of asset classes discussed on my blog, including all maturities of treasury, inflation linked treasury, municipal bonds, residential mortgage, other metals and agricultural commodities. We have also computed nominal returns (based on a 255 trading day convention), real returns, asset volatility and Sharpe ratio for each the asset classes across time periods to determine performance of each asset class over a period of time. Below is the summary charts and tables of our findings. (Pro subscribers, please refer to the attached excel document for detailed information for each time period - Q2 2009 Asset Inflation Correlation Datasheet 2009-06-12 14:21:51 2.47 Mb)

Agriculture commodities: Historically, agricultural stocks have not provide sufficient hedge against inflation because of lack of storability and more or less constant demand (which is not linked directly to level of economic activity unlike other commodities). Also due to supply shocks agricultural commodities have one of the highest volatility (in terms of standard deviation) and lowest Sharpe ratio. In addition agriculture commodities have low correlation with inflation, negative real returns (in almost all sub-periods) and low nominal returns.

Emerging markets, real estate and Gold offer one of the highest real returns in that order. However, lower volatility of commercial real estate sector makes this sector one of the most attractive in terms of risk-reward ratio. Within commercial real estate apartments have one of the highest real returns (after emerging markets) and highest Sharpe ratio amongst all asset class.

	*Nominal Return*	*Real Return*	*Standard deviation*	*Sharpe ratio*	Correlation
	*Nominal Return*	*Real Return*	*Standard deviation*	*Sharpe ratio*	Correlation
Commodities
Precious Metals
Gold	6.1%	3.0%	19.6%	0.16	0.68
Silver	3.9%	0.8%	30.8%	0.03	0.23
Non-ferrous metals
Copper	3.7%	0.6%	28.4%	0.03	0.46
Aluminum	-0.7%	-3.8%	24.4%	(0.15)	0.24
Lead	4.1%	1.0%	25.8%	0.04	0.57
Nickel	5.7%	2.6%	41.7%	0.06	0.52
Tin	1.3%	-1.8%	21.5%	(0.08)	0.61
Steel	0.3%	-2.8%	16.4%	(0.17)	0.39
Zinc	-0.5%	-3.6%	24.2%	(0.14)	0.46
Agriculture commodities
Live Cattle	1.8%	-1.3%	19.6%	(0.06)	0.88
Livestock	1.3%	-1.8%	19.2%	(0.09)	0.73
Sugar	1.0%	-2.2%	40.2%	(0.05)	(0.31)
Heat Oil	0.5%	-2.6%	33.4%	(0.07)	0.65
Lean Hogs	0.3%	-2.8%	31.1%	(0.09)	(0.19)
Coffee	0.3%	-2.8%	37.4%	(0.07)	(0.37)
Cocoa	0.1%	-3.0%	28.8%	(0.10)	0.09
Cotton	-0.6%	-3.7%	28.5%	(0.12)	(0.36)
Soybean	2.8%	-0.3%	30.1%	(0.01)	0.37
Wheat	2.6%	-0.5%	25.9%	(0.01)	0.33
Grains	2.6%	-0.6%	22.9%	(0.02)	0.34
Corn	2.3%	-0.8%	25.7%	(0.03)	0.31
Energy
WTI Crude	2.1%	-1.0%	34.3%	(0.03)	0.64

Real Estate Sector
Residential real estate
Residential (S&P Case Shiller)	2.8%	-0.3%	3.1%	(0.06)	0.87
Commercial real estate - Total Return (price + income)
NCREIF Property Index	6.5%	3.3%	4.2%	0.81	0.89
NCREIF Property Index - Apartment	7.4%	4.3%	4.3%	1.03	0.90
NCREIF Property Index - Industrial	6.7%	3.6%	4.2%	0.89	0.89
NCREIF Property Index - Retail	6.7%	3.6%	3.8%	0.98	0.88
NCREIF Property Index - Office	6.0%	2.9%	5.7%	0.52	0.87
Commercial real estate - Price return
Commercial Price Index	3.2%	0.1%	7.8%	0.03	0.94
Apartment Price Index	4.0%	0.9%	8.7%	0.11	0.96
Industrial Price Index	2.9%	-0.2%	10.1%	(0.01)	0.95
Retail Price Index	3.0%	-0.1%	8.4%	0.00	0.92
Office Price Index	4.0%	0.9%	8.2%	0.13	0.93

Equities
Domestic Equities
S&P 500	3.9%	0.8%	15.8%	0.06	0.00
Global Equities
MSCI World Index	4.7%	1.5%	15.3%	0.11	0.84
Emerging Markets
MSCI BRIC EM Index	4.8%	1.7%			0.75
Brazil	24.6%	21.5%	48.6%	0.45	0.92
China	4.7%	1.6%	44.3%	0.04	0.58
Russia	13.8%	10.7%	56.5%	0.19	0.79
India	11.7%	8.6%	29.0%	0.30	0.84
JPM Morgan Emerging Market Debt Fund	-2.5%	-5.6%			(0.25)

Treasury yields have declined significantly over a period of time. Except during 1970's (during high inflation) treasury yields have declined over past 3 decades and currently are at an all time low (pls refer to chart below and suscribers may referenced the attached excel file). High inflation coupled with economic recovery could cause yields to increase.

	Change in yield
Fixed Income	2000's	1990's	1980's	1970's	Correlation
Treasury Bonds
Short Term
Yield on Treasury (1-month)	(357)	n/a	n/a	n/a	0.64
Yield on Treasury (3-month)	(534)	(254)	(504)	n/a	0.63
Yield on Treasury (6-month)	(541)	(228)	(609)	n/a	0.63
Yield on Treasury (1-yr)	(557)	(208)	(434)	651	0.81
Intermediate Term
Yield on Treasury (2-yr)	(551)	(199)	(372)	433	0.76
Yield on Treasury (3-yr)	(517)	(199)	(311)	247	0.66
Yield on Treasury (5-yr)	(472)	(193)	(299)	359	0.71
Yield on Treasury (7-yr)	(423)	(182)	(292)	269	0.61
Yield on Treasury (10-yr)	(373)	(193)	(296)	300	0.68
Long Term
Yield on Treasury (20-yr)	(302)	62	(337)	254	0.66
Yield on Treasury (30-yr)	(287)	(191)	(270)	237

Inflation Adjusted Bonds
Inflation-indexed Treasury (5-yr)	(54)	n/a	n/a	n/a	(0.19)
Inflation-indexed Treasury (7-yr)	(81)	n/a	n/a	n/a	(0.26)
Inflation-indexed Treasury (10-yr)	(72)	n/a	n/a	n/a	(0.53)
Inflation-indexed Treasury (10-yr)	222	n/a	n/a	n/a	(0.83)
Municipal Bonds
20 yr Municipal Bond	(130)	(115)	(37)	59	0.43

Corporate Bonds
Investment Grade Corporate Bonds Yield (AAA)	(239)	(144)	(223)	283	0.56
High Yield Corporate Bonds Yield (BAA)	6	(175)	(260)	320	0.55

Mortgage Bonds
30-yr, Fixed-Rate Conventional Home Mortgage	(340)	(199)	(314)	559	0.60

International Bonds
S&P/Citigroup International Treasury Bond Index Ex-U.S.	(143)	n/a	n/a	n/a	0.17
Euro Govt Bond 10-15 yr	(167)	n/a	n/a	n/a	(0.07)
India Sovereign Zero Coupon Yield 10 Year	(479)	(86)	n/a	n/a	0.25
USD Brazil Sovereign Zero Coupon Yield 10 Year	(774)	128	n/a	n/a	(0.16)
USD- Euro Russia Sovereign 10 yr	(1,076)	n/a	n/a	n/a	(0.69)