Noise and signals

When the latest inflation figures were presented in the first half of May, the markets backed off in surprise. Consumer prices in the US had risen 4.2 percent on an annual basis in April, which was the fastest increase since 2008. Although Janet Yellen only a few weeks ago mentioned interest rate hikes as a possibility if not the embarrassing future of inflation would pull away too much was no one thought it was a sign that Yellen and others already knew that consumer prices had risen more than previously thought.

What is surprising about this story is that investors could not foresee what was happening. Recent months have offered more than one signal that consumer prices were on the rise, not least through sharply rising commodity prices that have seen global food price indices rise by several percentage points each month. Not to mention that the majority of CFOs from large companies such as Coca Cola, Whirlpool , Procter and Gamble to name a few, in recent quarterly reports have been clear that their margins have been squeezed so much by rising commodity prices that they are forced to raise prices.

So where should you as an investor invest your money if you want to best protect your capital against inflation? Which assets have historically performed worse or better during periods of high inflation, and how do you distinguish between noise and signals when trying to parry markets that may already be unfamiliar?

First and foremost, investors need to see reality for what it is. The way inflation is measured has changed and developed since the Federal Reserve was started in 1913. From the beginning, inflation was only a measure of the expansion of the money supply. When the United States was the last country to leave the gold standard, the definition was changed to a general increase in consumer prices. At the time, it was still believed that inflation was neither necessary nor even positive for the economy, but as money pressure has financed the state budget, the definition and mantra surrounding rising consumer prices has changed. From a target of less than 2 percent annually, to trying to reach 2 percent annually, and now, to trying to let inflation exceed 2 percent annually because, according to the Federal Reserve , it has been so far in recent years. However, that is far from the truth.

The black line shows inflation per year as reported by the Fed since 1990, and the red line an alternative inflation measure, which measures in the same way as for the black basket, before the contents of the basket used to measure inflation is replaced by other contents. Inflation is thus significantly higher than reported.

Historically, equities have been a worse alternative during periods of high inflation. And despite the fact that history leaves no guarantees for the future, it is more than rising inflation that indicates that equities may not be the most attractive investment in the coming years. In addition to the fact that equities are generally already traded at historically high multiples and stretched valuations, the inflation anxiety should also lead to the market pricing in interest rate increases with a 100 percent probability next year - something that could push down the valuations somewhat.

Instead, commodities have performed well during times of high inflation. The rally of recent months is, if one is to believe that the market is in an early stage of a new so-called supercycle, just the beginning of a longer period of rising real asset prices. If you also add that China's growth has led to a structural deficit of, among other things, agricultural raw materials, the outlook remains bright, despite the fact that the price of corn and soybeans, for example, has risen almost 100 percent in twelve months.