- the impact of sharply higher food and energy prices is being felt by households in the US and Europe
- the ECB is concerned about wage pressures and is signaling a hard line on interest rates due to rising inflation
- the Federal Reserve is weighing the risks of US economic slowdown versus increased inflation
- China is transmitting inflation via its demand for commodities, its new labour laws and expected revaluation of the yuan
The global economy has been through a long-term secular trend of declining inflation since the early 1980s, underpinned by sound central bank policy, rising productivity, technology, deregulation and globalisation.
Although there were far fewer hedge funds and hedge fund strategies in existence during the last phase of inflation, Permal was involved in the management of a fund of funds that invested heavily in macro strategies during the last inflationary era. Figure 1 shows very strong performance during these years, suggesting that the inflationary environment was accompanied by very profitable trading opportunities in currencies, fixed income and commodities. When inflation is introduced into the financial system, the trend of higher prices becomes somewhat ingrained, leading to more robust trends in these respective markets.
While it is difficult to analyse more recent historical relationships between hedge fund strategies and inflation, we can still tackle the question by looking at 1) performance of traditional asset classes in inflationary periods and 2) the context in which the current wave of rising inflation is occurring.
Inflation and traditional asset classes
On average, inflation is bad for bonds, mixed for equities and favourable for commodities and real assets. There is a strong systematic component to the returns of many hedge funds so if inflation is accompanied by falling markets then hedge funds returns will fall too, though typically not to the same extent. Accordingly, most long-biased fixed income hedge fund strategies would be expected to perform poorly and long-biased natural resources funds would perform well.While mainstream equity market indices may not make much progress, there is likely to be sharp divergence among sectors and stocks, creating attractive opportunities for long/short equity managers. As for merger arbitrage strategies, higher inflation should translate into higher risk premia, which would mean higher M&A spreads and expected returns for this strategy.
Inflationary periods typically lead to steepening yield curves which are positive for talented fixed income relative value managers. Finally, since inflation and the different policy responses to it cause dislocations in currencies, interest rates and other asset markets, the global macro managers have the potential to capitalise on the trading opportunities that arise.
Inflation in today's global context
Given the ongoing concern about economic slowdown/recession in the US, the current context is more about stagflation than inflation alone. Most of the above relationships are likely to still hold in a stagflationary environment although in general, we can expect greater adversity, higher volatility and fewer bright spots in terms of traditional asset markets. For example, emerging markets are less likely to decouple and prosper in a world of stagflation.Hedge funds depend on volatility to create mis-pricing opportunities. So if stagflation is accompanied by higher volatility then that will be good for hedge funds. Furthermore, economic downturns create attractive entry points for distressed hedge fund strategies.
In natural resources, the appropriate investment approach is to be trading-oriented rather than directional long-biased. In global macro currency and fixed income trading, the opportunities become abundant once again on the long and short side.
It is difficult to forecast how inflation/stagflation will play out in the coming quarters with so many other forces at work: credit crunch, US elections, liquidity from sovereign wealth funds, and diverging behaviour of the central banks of the world. The current malaise may continue or it may be followed by surprisingly strong equity market performance.
However, as we saw in 2007, a global economy in transition, coupled with increasing volatility and potentially rising inflation/stagflation, should favour experienced well-managed hedge funds over traditional investment strategies. Furthermore, within the hedge fund universe, macro trading and astute long-short equity management should outperform.
