Energy Proving Its Mettle As Inflation Hedge

Inflation is high – 40-year highs to be precise – and showing no signs of relenting. One can argue for days about the causes of inflation and the competence, or lack thereof, when it comes to solving it (or not), but the fact remains the Consumer and Producer Price indexes are high. Uncomfortably so.

Clearly, one of the problems is soaring energy prices. Not surprisingly, energy is the best-performing sector in the S&P 500 again this year and the only one that’s in the green in 2022. The Energy Select Sector SPDR (NYSEARCA:XLE), a widely followed exchange traded fund, is up 26.41% this year while the S&P 500 is in a bear market.

The upside being offered by the energy patch is all the more relevant when considering the tepid to downright poor returns offered by traditional inflation hedges, including Treasury Inflation Protected Securities (TIPS), gold and real estate.

Owing to the fact that that advisors cannot directly allocate client funds to inflation, the next best bet are securities with high betas to rising consumer and producer prices. This year, commodities and energy equities are taking the cake.

Other Important Considerations

Something else to take into account are various measures, some of which are forward-looking, some of which are not.

“CPI is available as a monthly time series, is seasonally adjusted, and represents the price change of a broad basket of goods and services, including shelter and energy. It is the most-watched inflation number, but also complicated as the basket changes regularly and some components like food and energy are volatile, leading to significant movements in the data,” notes Nicolas Rabener of FactorResearch. “BEIR is even more difficult to understand as it is derived by subtracting the yield of the U.S. Treasury Inflation-Protected Securities (TIPS) from the yield of the 10-Year U.S. Treasury bond. Theoretically, this represents the market’s expectation for inflation over the next 10 years. Higher or increasing spreads indicate rising inflation expectations, while negative or decreasing spreads imply falling inflation expectations.”

The less heralded and likely unfamiliar to many clients United States 10-Year Breakeven Inflation Rate (BEIR) is highly relevant because it’s calculated daily whereas the CPI is a monthly reading.

As Rabener points out, and it’s a point being reflected this year, the 10 stocks with the highest beta to BEIR are all energy stocks. Looking at mutual funds, that number drops to six with one of the four exceptions being a Latin America fund. That’s an energy-rich region and it’s likely the fund in question reflects as much. The other three exceptions are bank, mid- and small-cap funds.

Looking at ETFs, things get interesting here because each of the 10 ETFs with the highest betas to BEIR are leveraged funds, meaning they’re not applicable for client portfolios that geared for the long-term. Fortunately, each of these funds have ungeared, basic beta equivalents. Three of the ETFs on that list are dedicated energy funds while another two focus on Latin America, according to FactorResearch.

Two are plays on small-cap stocks while the other three are industry plays focusing on banks, biotech and industrials.

Ideas for Advisors

Allocating to the effect of inflation is tricky business. Even for advisors. Think about how rapidly inflationary pressures change. In 2020, rising prices were barely on the radar. Today, it’s practically an all-consuming issues. Fortunately, advisors have options and some can benefit clients.

“A better strategy is to allocate to managed futures strategies that benefit from either kind of environment. If inflation is rising or high, then these will likely pick up long exposure to commodities. If inflation is falling, then it might be long bonds and short commodities. Let the trend be your friend,” concludes Rabener.

Related: New Tool in Rising Rate, Inflation-Fighting Toolbox