Which assets perform well in inflationary conditions?

As previous blogs have pointed out, equity markets have consistently beat inflation, producing an average return of 6.5% after inflation in the US.  This is a simple average, however, so let’s look at whether there is a correlation between inflation and the rate of return for different asset classes.

Bennyhoff, and Donald G, wrote a paper in 2009 called  “Preserving a Portfolio’s Real Value: Is There an Optimal Strategy?”.

They looked at the average inflation rate from 1926 until 2008 , and then the real terms returns of different asset groups. They came up with the following results:

Annual inflation: Year-over-year basis point change Stocks total average return  Long-term Treasury bonds average return  Intermediate term treasury bond total return  T-Bills total average returns 
▲ 150 bps  –2.33  –4.81 -2.50 –1.99
▼ 150 bps and ▲ 20 bps 5.83 2.31 1.86 0.85
▼20 bps and ▲-40 bps  10.94 6.41 3.71 1.46
▼ –40 bps and ▲ –200 bps 20.37 3.01 3.03 1.55
▼ –200 bps 7.07 8.55 6.03 2.43

As the figures above show, there has been many years where average stock market returns have been much high than 6.5% after inflation, and other years where they have been much lower. Moreover, from 2008 until today, the price of stocks has certainly performed excellently, in a low-inflation environment. 

This backs up the researchers claim that “stock returns are not entirely independent of the inflationary environment, but, as can be seen in the table, some of their best and worst annual real returns have occurred whether inflation was rising or falling”.

For the other assets, because of the relationship between inflation and interest rates, sudden shifts in inflation expectations affect the total return of bonds much more than that of stocks. In fact, for bonds (particularly Treasury bonds), inflation shocks are the primary factor affecting performance; for stocks, inflation is just one influence among many.  

For bonds, on the other hand, the best real returns tended to occur when inflation was falling rapidly, and the worst when it was speeding upward. Changes in inflation expectations tend to result in changes in interest rates, which affect prices of longer-duration bonds more than those of shorter- duration investments like T-bills.

If we look at real rates of return by the decade, a similar pattern emerges 

CPI Inflation annualized  Stocks real    returns  Long-Term Treasury real returns  Intermediate-Term Treasury real returns  3-month T-Bill 
1930s  –2.04% 2.08% 7.06% 6.76% 2.70%
1940s 5.36 3.52  –2.01  -3.35%              –4.64%
1950s 2.22 16.66  –2.25  –0.86%             –0.17%
1960s 2.52 5.16 – 1.04 0.94% 1.47%
1970s 7.36 –0.32  –1.37 -0.11% 0.88%
1980s 5.10 10.98 7.34 6.33% 3.93%
1990s 2.93 14.24 5.48 4.05% 2.06%
Average (1926-2008)  3.01 6.44 2.60 2.25% 0.8%

I am sure one thing that surprises people is that in the 1930s during the Great Depression, US stock markets actually produced more than during the 1970s.  This is because prices started to recover after 1933, deflation affected the real rate of return, and by January 1  930, the Dow Jones price was already lower than it was during the height of 1929.   The figures also show it is common for stocks to under and outperform their historical averages of 6.5% after-inflation.  

What do these figures show for people’s portfolios then?  I would summarize the findings as:

  1. Once again shows why you shouldn’t panic if markets are down for a considerable amount of years.  The last 18 years are a great example of this.  Between 2000 and 2009, markets performed very badly by historical standards, whilst they have performed very well from 2009 until today.  
  2. Having a diversified portfolio with some government bonds will lower your long-term portfolios growth slightly, but will smooth out the ride, as they perform well during periods when stocks perform badly
  3. It is completely rational to be 100% in stocks when you are young, from age 21 until 40, but then go for 25% or more in bonds.  However, you need to be physiologically prepared for the falls as well as the rises.  
  4. If you start investing in the markets today and the markets have a bad 5-10 years, you should actually be happy, as that will further increase your long-term returns, if you are patient, as you are buying at lower prices.
  5. The markets always go up in the US, but the ride wasn’t been smooth.  So don’t try to find the best time to come into the market.
  6. For a well-diversified, strategically managed portfolio— such as most policy portfolios today—research has shown that asset allocation is the primary determinant of risk and return. For these reasons, the asset allocation decision should be the highest priority.
  7. For people in retirement, if the goal is to maintain long-term purchasing power and the liability stream is expected to grow at a rate similar to CPI-U, then investing the portfolio entirely TIPS or T-bills may be appropriate.
  8. However, if the goal is to increase the real value of the portfolio or if the liability stream is less certain, assets with potentially higher real returns probably should be included in the asset allocation.  
  9. Especially if you want to live for more than 30 years after retirement, it makes sense to have at least 50% in equities for a simple reason.  A 0.8% or even a 2.6% return after inflation isn’t much if you are withdrawing money from it every year.  In comparison, if you are getting a 5%-6.5% return after inflation, you can withdraw 4% from the portfolio every year and not run out. 

Adam Fayed – International AMG – adamfayed@iamgltd.com

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