It has been difficult to consume financial or economic news recently without being overwhelmed by inflation articles. Although these articles were circulating pre-pandemic, they have burst back into prominence over the past couple months. Some outlets are predicting sustained inflation over 3% while others, including Fed Chair Jerome Powell, believe the stronger inflation will be transitory and will drop back near their 2% target next year.
The Federal Reserve measures inflation using the price index for Personal Consumption Expenditures (PCE). However, the more widely followed measure is the Consumer Price Index (CPI), which measures the changes in prices of goods and services consumers purchase. Although similar, there are differences between the two. Over the past two decades, CPI has generally reported slightly higher inflation. As shown in the below graph, core CPI inflation has largely hovered around 2% over the past decade. As recent monthly year over year CPI figures have increased, inflation concerns have grown. The global pandemic has certainly made these figures difficult to interpret, as CPI figures from a year ago were during global lockdown mandates. To that point, it is reasonable to see moderate increases in CPI year over year. However, contrary to popular belief, it is impossible to tell what the future will hold. Looking at inflation through a diversified portfolio lens can be helpful.
CPI Inflation (%)
One of the main goals in investing is to increase wealth over the long term. Inflation poses a threat to this goal as it reduces purchasing power. If investment returns do not keep up with the inflation rate over extended periods, your overall wealth cannot grow in real terms (adjusted to consider effects of inflation).
There are many options within a diversified portfolio that can help provide protection against inflation. As seen below, from 1970 to 1981 during an extended period of particularly high inflation, some asset classes performed better than others.
|Asset Class||Annualized Nominal Return 1970-1981||Annualized Real Return|
|US Intermediate Term Government Bonds||6.9%||-1.0%|
|US Large Capitalization Stocks||6.9%||-1.0%|
|US Small Capitalization Stocks||13.8%||5.9%|
Source: Morningstar, US Intermediate Term Government Bonds: IA SBBI US IT Govt TR USD, US Large Caps: IA SBBI US Large Stock TR USD Ext, US Small Caps: AI SBBI US Small Stock TR USD, Global Commodities: S&P GSCII TR USD, Gold: LBMA Gold Price PM USD
From a high-level perspective, having an allocation to global equities within a portfolio can act as an inflation hedge over the long term. Historically, equity returns have outpaced inflation, thus providing a hedge against unexpected inflation. Furthermore, small capitalization companies have historically performed well during inflationary periods, especially relative to large capitalization stocks as referenced above. Companies, both large and small, can combat inflationary pressure in various ways that impact equity vs. debt investors differently. For example, Netflix can increase their monthly subscription cost by $1, thus increasing their cash flows to equity shareholders. A Netflix bond that is set to pay a fixed 3% interest rate over the next 10 years will not adjust.
Commodities and precious metals have long been viewed as an inflation hedge. As prices of goods and services rise, commodities have historically followed suit as they are used in the production of goods and services. Precious metals, specifically gold, have historically increased in price during times of a weakening dollar, which often occurs during periods of inflation.
Real estate usually performs well during inflationary periods. Historically, as inflation rises, real estate property values also have increased, acting as an inflation hedge. Real estate exposure within a portfolio is typically via a real estate investment trust (REIT). REITs come in many shapes and sizes and can be diversified globally as well as across different sectors such as office, industrial, retail, residential, and infrastructure, to name a few.
One of the purest inflation hedges are treasury inflation-protected securities (TIPS). TIPS are a type of treasury security issued by the US government that is indexed to the rate of inflation. As inflation rises, TIPS adjust in price to maintain their value in real terms. Similarly, floating rate bonds have a variable interest rate linked to a benchmark rate. During times of inflation, there can be upward pressure on interest rates, which give floating rate bonds some inflation protection qualities albeit not as pure as TIPS.
As with all investments, TIPS come with their own unique risk and return tradeoffs. As markets are forward looking, there is already increased inflation “priced in” to current market prices for TIPS. As seen in the below graph from the Federal Reserve Bank of St. Louis, the 5-year breakeven inflation rate is roughly 2.6%. This value implies what market participants expect inflation to be over the next five years, on average. As a result, if inflation does not hit that mark on average over the next five years, having an allocation to TIPS over that time period within the portfolio would not provide the desired purchasing power protection. Conversely, it would likely detract from overall performance relative to other fixed income instruments.
5 Year Breakeven Inflation Rate
Source: Federal Reserve Bank of St. Louis
U.S. recessions are shaded; the most recent end date is undecided
Our Investment Committee is continuously meeting to review market conditions and discuss any additions that may provide value to the portfolio. We have included allocations within our portfolios to many of the asset classes and securities discussed in this piece. Nobody knows the path inflation will take, but we will continue to monitor the landscape and look for opportunities to mitigate risks and position our portfolios moving forward. If you would like to discuss inflation or any other topics related to your investments, please reach out to your Private Wealth Manager and we would be happy to discuss in more detail.
Sources: PIMCO, Morningstar, Capital Economics “US Economics Focus”, Federal Reserve Bank of St. Louis, Federal Reserve Bank of Cleveland
Indexes are unmanaged baskets of securities that are not available for direct investment by investors. Index performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Foreign securities involve additional risks, including foreign currency changes, political risks, foreign taxes, and different methods of accounting and financial reporting. Emerging markets involve additional risks, including, but not limited to, currency fluctuation, political instability, foreign taxes, and different methods of accounting and financial reporting. All investments involve risk, including the loss of principal and cannot be guaranteed against loss by a bank, custodian, or any other financial institution.