Both requests come hand in hand with negative returns. In bear markets, there is a discount in flow expectations that translates into a drop in prices that reduce the value of the portfolio. For its part, in periods of high inflation, nominal returns are threatened, succumbing to negative real returns.
Bear markets: looking for proximity to liquidity and safety
In a bear market environment, the best coverage is to get out of the market and stay in cash or debt. If we are in investment funds, it would be a transfer to money market funds or debt that has an inverse correlation with the stock market and, as such, tends to rise in price as share prices fall.
We can think that it would be necessary to move away from fixed income since it barely pays returns in the current environment of low interest rates. But when it comes to balancing a falling market, this asset has consistently outperformed equities.
Global bonds returned 12% in 2008. Bonds also did well during the dot.com crash, posting gains of more than 8% in 2000, 2001 and 2002.
Another interesting asset is gold. It works very well as a refuge asset in high volatility environments, therefore, its correlation with the market is close to 0.
For all this, the permanent portfolio It works especially well in bear markets since 3/4 of it is made up of the aforementioned assets.
High inflation is fought with real assets
Contrary to popular belief, gold is not an asset that performs particularly well in losses where we see high rates of inflation.
An investment that is hedged against inflation would generally rise in tandem with rapidly growing consumer prices. Nevertheless, gold generated negative returns for investors during some of the highest recent inflationary periods.
Based on historical data, gold fell 10% on average between 1980 and 1984when the annual inflation rate was around 6.5% and 7.6% between 1988 and 1991, a context in which inflation was around 4.6%.
When we see unleashed inflation rates in which a high level of economic uncertainty is generated, then gold fulfills its function. From 1973 to 1979, the annual inflation rate averaged 8.8% and gold averaged 35%.
If we go to the statistical data, gold’s correlation with inflation has been relatively low (0.16) over the last half century. To understand it, a correlation of 0 means that there is no relationship, while a correlation of 1 means that they are in the same direction perfectly.
So how should we rotate portfolio if we see inflation?
What works best in periods of high inflation are real assets such as infrastructure that has a positive correlation with inflation, especially when combined with high economic growth.
Real assets can assimilate inflation through a higher revenue growth due to higher rental growth, employment and a higher demand for the underlying good, such as electricity. The risk of accelerated expense growth is mitigated primarily through contractual adjustments in leases or contracts, expense transfers, higher replacement costs and leverage.
Under this reasoning, we can invest in Socimis that benefit from adjustable rental income, acquire a home with leverage, or invest in companies with a high weight of fixed assets compared to the total.
The chart below shows the correlation of monthly relative returns against the monthly inflation rate for the 11 sectors. The conclusion is clear: the relative returns of the energy sector have been positively correlated with inflation on all occasionswhile consumer discretionary and financials have been negatively correlated on all occasions.
In the same way, commodities are also a tangible asset. Raw materials are simply means of production: oil, gas, copper, cattle, etc. As with real estate, the value of these assets increases with inflation.