Markets roiled by inflation leave investors with nowhere to hide

By Denitsa Tsekova

For inflation-stricken investors, a very bad year looks even worse.

As stock prices plummeted and bonds suffered their deepest losses in decades, the surge in consumer prices earlier this year turned some corners of the financial markets into profitable havens. Oil prices recovered. Other commodities did as well. Rising house prices and rents also supported the real estate sector.

But the hiding places disappear quickly.

That’s because the continued rise in core inflation — which eclipses volatile food and energy prices — will push the Federal Reserve to continue its most aggressive series of rate hikes in decades. And that’s bad for assets of all stripes.

A new study by researchers at the University of Pennsylvania and the University of Hong Kong found that stocks, bonds, commodities and real estate mutual funds all face losses if core inflation unexpectedly rises, according to data from 1963 to 2019.

“In the first half of the year, when energy and food inflation was outpacing nuclear, commodities did great and looked like a great hedge against inflation,” said Nikolai Roussanov, a finance professor at the University of Pennsylvania’s Wharton School who wrote the study written. “But as energy prices started to fall, we saw the correlation reverse and commodities in general didn’t do as well.”

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The shift adds to the darkening outlook in global financial markets, which have been hit hard this year as central banks around the world tightened monetary policy, marking a sharp break with the easy-money era that helped stocks and bonds prosper to recover from the pandemic.

On Tuesday, the US Department of Labor reported that the core CPI rose 6.3 percent year-on-year in August, the first acceleration since March. The numbers dashed investors’ hopes of a slowdown and solidified expectations that the Fed will hike interest rates by three-quarters of a percentage point on September 21 for the third straight month.

Such aggressive tightening increases the risk of a sharp economic slowdown, which would hurt corporate profits and demand for commodities such as oil.

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The S&P 500 Index plunged more than 4 percent on Tuesday alone after the inflation report and ended the week down almost 5 percent. A Bloomberg commodities index has fallen 3 percent since Tuesday. And Treasury yields have soared, pushing US Treasuries down more than 11 percent this year, by far the worst since the Bloomberg index began in 1973. The US dollar has been one of the few bright spots, with the Currency was pulled up by the rise in interest rates.

According to Roussanov and his fellow researchers, the shift in commodity markets is consistent with what has been observed since the early 1960s. While commodities return 21 percent when energy inflation rises one standard deviation, they actually fall 0.1 percent when core inflation experiences the same jump.

A similar study by researchers at hedge fund firm Man Group Plc and Duke University also found that both stocks and bonds tend to underperform during periods of inflation, while commodities are the only major asset class that reliably outperforms when inflation is high. But the caveat is that once headline inflation starts falling from its peak, the return for the asset class tends to be zero, according to one of the authors.

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“The entire market and the world is navigating from this period of high and rising inflation that we are in to a period of still high but lower inflation,” said Teun Draaisma, portfolio manager at Man Group. “We are on the threshold of this change.”

The shift is fueling a move out of commodity funds as investors brace for slower economic growth or a recession. Broad-based commodity ETFs are expected to withdraw cash in September for the fifth straight month, with nearly $17 billion withdrawn since early May. “If core inflation is very strong, that means aggressive monetary tightening will occur,” said Peter Chatwell, head of trading global macro strategies at Mizuho International Plc. “This should reduce demand in the near term and push most asset prices lower.”

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