By Edoardo Cilla, investment strategist, Investment Strategy Group, Vanguard Europe, and Lukas Brandl-Cheng, investment strategy analyst, Investment Strategy Group, Vanguard Europe

With headline inflation climbing to its highest levels in decades across many developed economies, lots of investors are worried about the ability of their investment portfolios to keep pace.  The latest estimate by Eurostat puts euro area inflation at 5% in December 2021 – the highest in decades.

As per our 2022 economic and market outlook, Vanguard thinks inflation will continue to climb across most economies in the first half of 2022 before cooling towards targeted levels by the end of the year.

Even with the expected cool-down, we still think euro area inflation will remain elevated compared to pre-pandemic levels at just above 2% by the end of 2022. Of course, our expectations are just that – expectations – and inflation could conceivably persist around current levels.

Whether inflation levels persist or cool, the concern among investors is very real. Indeed, when asked about the biggest risks to the economy and markets in 2022, the most common option identified by the investors we polled last month was ‘higher inflation’ (36%)1. With this in mind, our analysis of the performance of different asset classes under inflationary environments may help investors better understand how they can protect their portfolios from the corrosive effect of inflation on portfolio returns.

Inflation beta and volatility

For investors looking to hedge inflation risk over the short term, an asset class’ sensitivity to inflation (beta) is the best way of measuring its ability to keep pace with inflation. Unlike correlation, which only captures the direction of co-movement between the asset's returns and inflation, inflation beta captures both the direction and the magnitude of the co-movement.

Inflation beta is defined as how much an asset’s return increases when inflation goes up by one percentage point, and it represents the true inflation-hedging property of the asset. A beta score of one means the asset moves, on average, in lockstep with inflation.

We compared one-year returns with the one-year change in the euro area consumer price index (CPI) to analyse the inflation beta of various asset classes and ultimately understand their inflation-hedging qualities over a short-term investment horizon. As the chart below illustrates, commodities (since 1992)2 and gold have historically offered euro area investors the greatest inflation hedge over the short term. Global and local equities on the other hand registered an inflation beta below one.

Short-term inflation-hedging properties of different asset classes

Sources: Vanguard calculations, based on data from Bloomberg and the OECD.
Notes: Volatility is calculated as the standard deviation of rolling one-year annualised returns, at monthly frequency. Inflation beta is defined as how much an asset's return increases when inflation goes up by 1 percentage point. The sample period is 31 January 1976 to 31 October 2021. Due to data availability, the sample for global and euro aggregate bonds, inflation-linked bonds and government bonds starts on 31 December 2000. Prior to the launch of the MSCI EMU in 1998, we use MSCI Europe returns data. For euro area inflation, we use GDP-weighted inflation of Germany, France, Italy and Spain before 1990 as a proxy. We show the analysis of commodities for both the sample starting in 31 January 1972 and 31 January 1992 to highlight the regime-dependence of the inflation-hedging properties of commodities. Indices used: global equities - MSCI World Net Total Return Index; euro-area equities = MSCI EMU Net Total Return Index; global aggregate bonds (hedged) = Bloomberg Global Aggregate Total Return Index (Hedged EUR); euro area aggregate bonds = Bloomberg EuroAgg Total Return Index; inflation-linked bonds = Bloomberg Euro Govt Inflation-Linked Bond All Maturities Total Return Index; government bonds = ICE BofA Euro Government Index; commodities = S&P GSCI Index Spot; gold = Gold Spot.

However, high-inflation-beta assets don’t come risk-free. Higher return volatility associated with commodities and gold means an allocation to these asset classes could significantly alter the risk profile of an investor’s portfolio.

It’s also important to remember that, from a euro area investor’s perspective, commodities are exposed to foreign exchange risk (unless properly hedged). Further, inflation is not the only variable that can impact the performance of commodities.

Equities offer long-term protection

Over longer-term horizons, equities have typically offered positive returns in excess of the rate of inflation. The next chart shows the proportion of real returns higher than 0% (that is, a positive return after inflation) for five-, 10- and 20-year horizons.

Historically, as the results show, investing in global equities has offered the greatest chance of achieving a positive real return with a lower level of risk relative to gold and aggregate commodities.

Proportion of long-term positive real returns for gold, commodities and equities

Past performance is not a reliable indicator of future results.

Sources: Vanguard calculations, based on data from Bloomberg and the OECD.
Notes: The chart shows the proportion of real five-, 10- and 20-year returns that have been above 0%. The sample period for the monthly data is 31 January 1975 to 31 October 2021. Volatility is calculated over monthly returns of the entire sample period. Indices used: global equities = MSCI World Net Total Return Index; euro-area equities = MSCI EMU Net Total Return Index; commodities = S&P GSCI Index Spot; gold = Gold Spot.

Ultimately, global equity markets offer an effective long-term hedge against the risks of inflation. Over shorter time frames, commodities and gold are more likely to outpace the rate of inflation but come at the expense of higher return volatility (relative to equities), leaving investment portfolios more vulnerable to swings in value.

Further to that, the performance of high-inflation-beta assets is predicably strong in high inflationary environments, but should a high-inflation scenario not play out, the performance of these assets may drag on returns relative to a traditional multi-asset portfolio of equities and bonds. Titling portfolios towards gold and commodities to hedge inflation incurs a level of forecast risk, and if maintained for too long investors could miss out on long-term equity risk premium.

Sticking with a long-term strategy

Clients concerned about the impact of inflation on their investment returns ought to consider their investment horizon and tolerance for risk before making any changes to asset allocation. For many investors, the best course of action will be to maintain a globally diversified portfolio of equities and bonds, perhaps tweaking the mix of equities and bonds should individual circumstances or objectives change.

Using the Vanguard Capital Markets Model (VCMM), our proprietary forecasting framework, we looked at what euro area investors might reasonably expect from a globally diversified portfolio of 60% equities and 40% bonds in real terms (accounting for inflation) over 10- and 30-year investment horizons. Our analysis suggests a 60/40 portfolio is likely to return about 3% annually, on average, in real terms over the next 30 years3.

With real returns likely to be low over the next decade, keeping costs low will be crucial for investors to get the most from their investments.


1  Source: Vanguard, as at 6 December 2021. Number of respondents = 126.

2 The relationship between aggregate commodities and euro area inflation seems to be time-dependent: commodities tended to show a beta higher than 1 after the early 1990s but did not help to hedge inflation in the 1970s.

Source: Vanguard, as at 30 September 2021. Notes: forecast corresponds to distribution of 10,000 VCMM simulations for 10-year and 30-year annualised real returns in EUR for a portfolio of 60% global equities and 40% global bonds. Global equities = MSCI AC World Index, global bonds = Bloomberg Global Agg Index. All indices in EUR.  

IMPORTANT: The projections or other information generated by the Vanguard Capital Markets Model® (VCMM) regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.

The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.

The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include US and international equity markets, several maturities of the US Treasury and corporate fixed income markets, international fixed income markets, US money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.

Investment risk information

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

Past performance is not a reliable indicator of future results.

Simulated past performance is not a reliable indicator of future results.

Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.

Important information

This is an advertising document. For professional investors only (as defined under the MiFID II Directive) investing for their own account (including management companies (fund of funds) and professional clients investing on behalf of their discretionary clients). In Switzerland for professional investors only. Not to be distributed to the public.

The information contained in this document is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so. The information in this document does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this document when making any investment decisions.

Issued in EEA by Vanguard Group (Ireland) Limited which is regulated in Ireland by the Central Bank of Ireland.

Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.

© 2022 Vanguard Group (Ireland) Limited. All rights reserved.

© 2022 Vanguard Asset Management, Limited. All rights reserved.

© 2022 Vanguard Investments Switzerland GmbH. All rights reserved.