Hedging inflation risk
Recession fears are fading, but inflation concerns are on the rise.
April 2024, From the Field
Risks have shifted. From the beginning of 2022 through the first half of 2023, investors were concerned about recession risk, given slowing economic growth, elevated inflation, and a hawkish Fed. These fears were further validated by The Conference Board’s index of leading economic indicators plunging toward recessionary levels.
But the U.S. economy has proven to be much less sensitive to interest rate increases than expected, and leading economic indicators have been improving for more than a year.
As recession concerns fade, a new but familiar concern has retaken center stage: inflation. A simple examination of the trends in Bloomberg’s economists’ expectations shows that GDP growth for 2024 is now expected to be a healthy 2.1%. Meanwhile, expectations for the change in the consumer price index in 2024 have steadily risen from 2.2%—a level that would have been very much in line with the Fed’s targeted level—to 2.8% as of March 22, 2024.
The steady progress on inflation since CPI peaked at 8.99% in June of 2022 appears to have halted. Just one year after the peak, CPI had fallen to 3.05% in June 2023. But over the ensuing eight months, it has moved sideways, ending at 3.17% in February 2024.
The reason inflation has become so sticky relates to its composition. At its peak, elevated goods prices—specifically the food, energy, and core goods categories of the CPI basket—were the problem. These categories accounted for approximately 6% of the 9% figure, and they also accounted for the vast majority of the subsequent fall in inflation, which was heavily driven by the normalization of supply chains.
Meanwhile, there has been little to no decrease in services inflation, which is now responsible for the vast majority of inflation. This does not bode well for further improvement, as services inflation is typically very stubborn, outside of recessionary periods.
Perhaps even more concerning is the fact that inflation is at 3.17%, with practically zero contribution from goods categories. This means that to get inflation closer to the Fed’s 2% target, not only do we need the notoriously stubborn services inflation category to moderate, but goods inflation also needs to stay completely dormant, which is an optimistic assumption.
The bottom line is that risks have shifted from recession to inflation, which means investors may want to consider shifting their asset allocation as well. An examination of asset returns during various levels of CPI yields interesting insights that may be helpful to these considerations.
Historically, bonds, as measured by the Bloomberg Aggregate Bond Index, have been an excellent hedge for recession, but they have not been effective at hedging against elevated inflation. During the rare periods where inflation has turned negative due to sharp economic downturns, bonds have outperformed stocks, as measured by the S&P 500 Index. But as inflation levels rise, that dynamic shifts.
Meanwhile, stocks have tended to perform best when inflation was at low, moderate, and even slightly elevated levels—posting double-digit returns when inflation was between zero and 4%. But the returns dipped sharply during recessions and also weakened when inflation moved to very high levels. However, stocks in the energy sector have historically performed quite well in periods where inflation was at very high levels.
These results imply that one way to hedge inflation risks would be to tilt portfolios toward stocks, with an emphasis on the energy sector.
Given these shifting risk dynamics, our Asset Allocation Committee has recently moved to an overweight position in stocks and an underweight position in bonds. To further complement our hedges against inflation risk, we also hold an overweight position in real assets equities, which includes a large allocation to energy and other commodity-oriented equities.
Key Insights
- Recession fears are fading, but inflation concerns have resurfaced as consumer price index expectations have steadily risen since the beginning of the year.
- To hedge against inflation risk, T. Rowe Price’s Asset Allocation Committee is overweight stocks, with an overweight allocation to real assets equities.
Tim Murray, CFA
Capital Markets Strategist Multi-Asset Division
Risks have shifted. Recession fears are fading, and economists now expect a healthy 2.1% growth in U.S. gross domestic product in 2024. However, inflation concerns have resurfaced. Expectations for the U.S. consumer price index (CPI) have steadily risen from 2.2%—a level that would have been in line with the Federal Reserve’s target—to 2.8% as of March 22, 2024.
CPI, a widely used measure of inflation, surged to a peak in June 2022 due to elevated goods prices, specifically in the food, energy, and core goods categories of the CPI basket. As supply chains normalized, inflation fell as prices in these categories declined. Meanwhile, services inflation has barely budged and now accounts for the vast majority of inflation (Figure 1).
Inflation has fallen since the 2022 peak but looks sticky
(Fig. 1) Components of the consumer price index
January 2019 to February 2024.
Sources: Federal Reserve Board, Federal Reserve Bank of Philadelphia, University of Michigan/Haver Analytics.
Energy stocks have performed well in high-inflation environments
(Fig. 2) Average one-year asset class returns by monthly CPI ranges
December 1989 to February 2024.
Past performance is not a reliable indicator of future performance.
Sources: T. Rowe Price analysis using data from FactSet Research Systems Inc. All rights reserved. S&P and Bloomberg indexes. See Additional Disclosures.
This is concerning to investors. In order to meet the Federal Reserve’s 2% target, not only will the stubborn services inflation have to moderate, but goods inflation will also have to remain dormant. This is a very optimistic assumption.
Given the shift from recession risk to inflation risk, we believe that investors should reconsider their asset allocation. A review of asset returns during various inflationary environments provides some useful insights (Figure 2).
As illustrated, bonds historically have been an excellent hedge in recessionary periods, but they have not been an effective hedge against elevated inflation. Meanwhile, stocks have outperformed bonds when inflation was at low, moderate, and even slightly elevated levels. But their returns dipped sharply during recessions and also weakened when inflation moved to very high levels.
Notably, stocks in the energy sector historically have performed quite well in periods where inflation is at very high levels. These results imply that a tilt toward stocks, with an emphasis on the energy sector, could be a way to hedge inflation risk.
The Asset Allocation Committee recently moved to an overweight position in stocks. We also hold an overweight position in real assets equities, which have a large allocation to energy and other commodity-oriented equities.
Additional Disclosures
CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.
The S&P indexes are a product of S&P Dow Jones Indices LLC, a division of S&P Global, or its affiliates (“SPDJI”) and have been licensed for use by T. Rowe Price. Standard & Poor’s® and S&P® are registered trademarks of Standard & Poor’s Financial Services LLC, a division of S&P Global (“S&P”); Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”); T. Rowe Price’s Products are not sponsored, endorsed, sold or promoted by SPDJI, Dow Jones, S&P, their respective affiliates, and none of such parties make any representation regarding the advisability of investing in such product(s) nor do they have any liability for any errors, omissions, or interruptions of the S&P indexes.
Bloomberg® and Bloomberg US Aggregate Bond Index are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the index (collectively, “Bloomberg”) and have been licensed for use for certain purposes by T. Rowe Price. Bloomberg is not affiliated with T. Rowe Price, and Bloomberg does not approve, endorse, review, or recommend T. Rowe Price. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to T. Rowe Price.
Important Information
This material is being furnished for general informational and/or marketing purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, nor is it intended to serve as the primary basis for an investment decision. Prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.
The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.
Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date written and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.
The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request. It is not intended for distribution to retail investors in any jurisdiction.
Australia—Issued by T. Rowe Price Australia Limited (ABN: 13 620 668 895 and AFSL: 503741), Level 28, Governor Phillip Tower, 1 Farrer Place, Sydney NSW 2000, Australia. For Wholesale Clients only.
Canada—Issued in Canada by T. Rowe Price (Canada), Inc. T. Rowe Price (Canada), Inc.’s investment management services are only available to Accredited Investors as defined under National Instrument 45-106. T. Rowe Price (Canada), Inc. enters into written delegation agreements with affiliates to provide investment management services.
EEA—Unless indicated otherwise this material is issued and approved by T. Rowe Price (Luxembourg) Management S.à r.l. 35 Boulevard du Prince Henri L-1724 Luxembourg which is authorised and regulated by the Luxembourg Commission de Surveillance du Secteur Financier. For Professional Clients only.
New Zealand—Issued by T. Rowe Price Australia Limited (ABN: 13 620 668 895 and AFSL: 503741), Level 28, Governor Phillip Tower, 1 Farrer Place, Sydney NSW 2000, Australia. No Interests are offered to the public. Accordingly, the Interests may not, directly or indirectly, be offered, sold or delivered in New Zealand, nor may any offering document or advertisement in relation to any offer of the Interests be distributed in New Zealand, other than in circumstances where there is no contravention of the Financial Markets Conduct Act 2013.
Switzerland—Issued in Switzerland by T. Rowe Price (Switzerland) GmbH, Talstrasse 65, 6th Floor, 8001 Zurich, Switzerland. For Qualified Investors only.
UK—This material is issued and approved by T. Rowe Price International Ltd, Warwick Court, 5 Paternoster Square, London EC4M 7DX which is authorised and regulated by the UK Financial Conduct Authority. For Professional Clients only.
© 2024 T. Rowe Price. All Rights Reserved. T. ROWE PRICE, INVEST WITH CONFIDENCE, and the Bighorn Sheep design are, collectively and/or apart, trademarks of T. Rowe Price Group, Inc.
ID0006939 (04/2024)
202404-3518882