Inflation Eats Up Gains in Post-COVID Bull Market

The real return is even worse for the tech-heavy Nasdaq 100 and the Russell 2000 of small-cap stocks, which are down roughly 15% and 25%, respectively.

"Anyone who tells you we are in a bull market has got a lot of explaining to do," said Mike Wilson, chief U.S. equity strategist at Morgan Stanley. "Perhaps, stocks are no longer the inflation hedge investors expect."

That argument held that corporate America tends to benefit in a high-inflation environment in part because it can pass on rising costs to end consumers. And that resilience in earnings can help stocks thrive.

Profit estimates for this year and next have gone up in the past 12 months. Yet with the Fed committing to raise rates to battle inflation running at a four-decade high, the specter of higher borrowing costs has sparked a quick reassessment of equity valuations and a broad selloff.

Commodities have rallied, with a Bloomberg measure tracking everything from oil to wheat climbing more than 40% over the past year.

Still, Societe Generale strategists led by Andrew Lapthorne warn investors not to lean too much on the asset, in part because of its "notoriously volatile" prices that can be affected by idiosyncratic factors, such as geopolitical events or seasonal variations.

"We want to be long inflation up until the point tightening creates the conditions whereby supply and demand are brought back into balance by an economic slowdown or, even worse, a recession," Lapthorne wrote in a note last week.

'A Game of Chicken'

"In that regard, commodity prices, bond yields and equities are all involved in a game of chicken with central bank tightening. If central banks are successful, these inflation hedges will become problematic," he said.

To mitigate the risk, the team created a multi-asset model to hedge inflation. In commodities, rather than wagering on further gains, they developed a trend following strategy to ride the ebbs and flow of prices.

Similarly in bonds, they're long yield volatility, as opposed to placing an outright bet on a continued rise in rates. In stocks, the model calls for better returns from inflation beneficiary versus the market.

"We are simply changing the implementation of what are traditional inflation hedges," Lapthorne said. "We like the logic of being long the problem (commodities), being long a reaction to that problem (rates volatility) and being long the beneficiaries of that problem (inflation-linked equities)."

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