Inflation expectations are at the heart of any consumption and investment decision of households and businesses in the economy. They are also Inflation expectations are at the heart of any consumption and investment decision of households and businesses in the economy. They are also important for monetary policy: in the short term, they are a measure of the effectiveness of the policy; longer term, they are a measure of the credibility of central banks. No wonder, then, that their dynamics are studied so closely by academics and policy makers.
The UK inflation rate hit a 40-year high of 10.1 per cent in July and economists expect the country to have the highest inflation in the G7 through 2024. The situation is not much better in Europe or the US.
Should long-term investors like family offices be concerned about inflation? The answer is a big yes. Fiat currency debasement is a true risk for investors. For example, the purchasing power of one dollar was cut in half in the last 30 years and this was before the most recent uptick in inflation. The situation is similar for the pound sterling. A recent paper, US Inflation and Global Asset Returns, addresses this topic by answering the following two research questions:
1 Which asset classes are able to outpace inflation?
2 Which asset classes are an effective hedge to inflation?
In fact, investors have three options:
1\. Invest in assets that outpace inflation
(research question number 1), which can be riskier than an investor risk profile
2\. Invest in assets that are an effective hedge against inflation (research question number 2), which can have lower returns than an investor desired target return (but of course, lower risk too)
3\. A mix of the two options
The study reviews the relation of 23 US-based asset classes and strategies over almost 100 years, from 1927 to 2020 and a shorter timeframe from 1991 to 2020 (to include seven international asset classes).
Inflation is defined as the Consumer Price Index for All Urban Consumers (CPI-U, not seasonally adjusted) from the Bureau of Labor Statistics and it is calculated and studied as contemporaneous, lagged, expected and unexpected.
Over the longer sample, median inflation was 0.47 per cent per year in low-inflation years and 5.5 per cent per year during the high inflation sample.
The great news is that ALL BUT ONE (T-bills) asset had positive average real returns in both low and high inflation periods. For example, US stocks had real returns of 13 per cent in low inflation years and 5 per cent in high inflation years.
Over the shorter sample, median inflation was 1.5 per cent per year in low inflation years and 3 per cent per year in high inflation years, representing moderate numbers. Most assets had positive average real returns in both high and low inflation years, with the exception of energy stocks and commodities, which show negative real returns in low inflation years. International stocks had a 5 per cent real return in low inflation years and 7 per cent in high inflation years. Non-US bonds had real returns of about 4 per cent in both high and low inflation years.
We can answer affirmatively to research question number one, since the vast majority of asset class do outpace inflation over the long term. Great news for investors!
What about the second research question? The answer is less intuitive than we think because the researchers show weak correlations over time between nominal returns and inflation (whether contemporaneous, lagged, expected or unexpected). The only exceptions are energy stocks and commodities. But even in these cases, more than half of the assets’ nominal return variation was unrelated to inflation.
Again, and to conclude, what is an investor to do? In the words of the authors:
“The right mix of assets for growth and hedging purposes ultimately depends on an investor’s goals and needs. The good news is that most of the global assets we study have been able to outpace US inflation over the long term. Hence, simply staying invested may by itself be an effective long-term solution to inflation concerns.”
In other words, before considering changing your portfolio allocations, sticking to a robust and well-planned investment policy statement and strategic asset allocation is the best long-term strategy.
