The combination of loose monetary policy and massive U.S. debt has led to concern about looming inflation. The commonly accepted belief is that a healthy allocation to equities can serve as an inflationary hedge as returns on stocks have far outpaced both bonds and inflation from 1926 to the present - but does this tactic work in the short-term?
To answer that question, and to help you properly set client expectations, we have examined the performance of several different asset classes during a number of short-term inflationary periods (less than five years) dating back to 1936, and what we found doesn’t necessarily harmonize with conventional wisdom. We also thought it worthwhile to examine the pros and cons of investing in relatively newer asset classes such as TIPS and Floating Rate Loans to decide if they warrant an allocation in an inflation-focused portfolio.
To begin, we separated the inflationary periods we examined into two categories: pre-1971 and post-1971 (when the United States officially came off of the gold standard). It’s important to make the distinction between the two as the price of gold remained relatively fixed from 1936-1971 and, as a result, did not behave the same as it does in modern markets. Therefore we did not include gold in the pre-1971 comparison. Instead we focused our study on the performance of 30-day treasury bills, a 50/50 combination of intermediate and long-term government bonds, and large and small cap equities.
The pre-1971 inflationary periods were overall in-line with what most people expect in terms of asset class performance. Government bonds failed to outpace (in 4 out of 5 inflationary periods) while large and small cap equities outperformed inflation in three of five inflationary periods. Figure 1 illustrates these results.
Moving on to the post-1971 category, we examined six different inflationary periods (see Figure 2). It is
important to keep in mind that after interest rates peaked in the latter part of 1981, they began a steady decline to today’s historically low rates. As a result, bonds fared much better during the post-1971 inflationary environments.
Performance During Inflation
Figure 3 demonstrates that bonds outpaced inflation in the three most recent inflationary periods that we examined and Treasury bills startlingly outstripped inflation in two of the six periods. In terms of equity performance during all six periods, there was no discernible pattern that existed as equities outperformed in some of the periods while underperforming in others and there appeared to be no real correlation between large and small cap performance. If there was one fairly consistent theme that held during all of post-1971 periods, it would be gold’s steady outperformance.
The Newer Asset Classes and Inflation Performance
In addition to the traditional asset classes we have discussed, today’s investors have access to relatively new asset classes, such as TIPS and floating rate loans, that are more or less designed to protect against inflation
risk; however, there is limited historical data to evaluate how they actually perform in various markets. TIPS, or “Treasury Inflation Protected Securities,” are designed in such a way that their underlying principal value adjusts semi-annually to align with the CPI index, which thus offers protection against unexpected inflation. In the two most recent periods we examined, (7/02-10/05 and 11/06-8/08) TIPS have managed to outperform inflation by posting annualized returns of 6.5 and 6.8%, respectively, versus annualized inflation rates of 2.6% and 3.8% over the same periods.
Floating rate loans are designed so that their interest rate resets every 60 to 90 days to a market rate plus a spread. This feature makes them less vulnerable to the interest rate risk, which negatively affects other fixed income products in inflationary environments when the Fed attempts to combat inflation by raising rates. Floating rate loans managed to outperform inflation in Period 5 but failed to keep pace with inflation in Period 6 due in part to interest rates dropping over that same period. In today’s environment, where interest rates have almost nowhere to go but up, floating rate loans deserve consideration.
In order to make prudent portfolio positioning decisions, it’s important to understand how certain asset classes perform in different inflationary environments. What we have found is that pre-1971 equities generated the best real returns during inflationary environments and that post-1971 gold has been the best play--this seems to fit with conventional wisdom. Post-1971, equities have failed to consistently outpace inflation during short-term inflationary environments; however, they have outperformed inflation over the long-term.
TIPS and floating rate loans have certain features that are advantageous in inflationary environments; however, due to their limited track records, it can be tough to gauge how they’ll perform in various market environments.
Author’s disclaimer: The views and opinions expressed are provided for general information only and do not constitute specific investment advice or recommendations from the author.
Note: In order for a period to be considered “inflationary,” Consumer Price Index (CPI) returns on annualized rolling 12-month basis had to increase for at least 12 months. Also, the annualized inflation over that same time period had to be greater than the long-term historical inflation rate of 2.5%.