Publications

- April 1, 2018: Vol. 5, Number 4

Where to invest if inflation picks up: What historical data tells us about how asset classes have performed in different inflation scenarios

by Gregg Fisher

Inflation is as violent as a mugger, as frightening as an armed robber, and as deadly as a hit man.

That quote, from former President Ronald Reagan, seems almost quaint today, when the Federal Reserve (among other central banks) struggles to push the inflation rate up to 2 percent. Since 2009, inflation has been subdued globally, making it difficult to conceive of a return of the dreaded monetary hit man. Yet in recent months, some prices and key measures of inflation expectations have sprung to life again.

From June 2017 to Jan. 25, 2018, oil prices surged 54 percent and broad-based commodities (S&P GSCI index) gained 31 percent. The 10-year inflation break-even rate, a measure of inflation expectations that reflects the yield differential between 10-year Treasuries and comparable Treasury inflation-protected securities (TIPS), widened from 1.7 percent in June 2017 to 2.1 percent Jan. 25. The labor market, with unemployment at 4.1 percent, is tight; economic growth, fairly robust in recent quarters, should be further stimulated by the large-scale tax cuts that kick in this year; and the weak U.S. dollar should translate into higher prices of imports.

With that backdrop, it is timely to look back to assess how asset classes have performed under different inflation scenarios. We reviewed more than 30 years of data and studied two separate inflation environments: “positive unexpected inflation,” which we define as periods with 12-month actual changes in the U.S. Consumer Price Index that were at least 0.5 percentage points higher than forecasted; and asset returns during low-, medium- and high-inflation regimes.

CPI AND ASSET CLASS RETURNS

A review of one-year returns of more than a dozen asset classes during periods of unexpectedly high CPI rates shows, perhaps unsurprisingly, the winner is commodities, which on average jumped nearly 28 percent in times of unanticipated spurts of inflation. Other hard assets (gold and REITs) also proved to be worthy hedges against inflation shocks. Interestingly, equities from developing countries, many of which are heavily exposed to natural-resource industries, outperformed gold and REITs, and returned more than twice as much as U.S. and other developed-country equity markets.

For the second study, we defined inflation scenarios like this:

  • Low — year-over-year CPI of less than 2.1 percent
  • Moderate — 2.1 percent to 3.2 percent CPI
  • High — inflation of greater than 3.2 percent

Historical data shows commodities again took the crown in high-inflation periods, returning 23.6 percent to investors, while suffering severe losses in low-inflation environments. TIPS and U.S. REITs both registered double-digit returns during high inflation, and second place was again taken by emerging-market equities, rising 18.5 percent, though they badly trailed U.S. and developed-international stocks in low-inflation periods.

CONCLUSION

Predicting future inflation rates is extremely difficult, and I make no forecasts here. But because inflation — and particularly unexpected bursts of inflation — can play havoc with the performance of some asset classes, there is a strong case for a well-diversified portfolio to include an allocation to hard-asset inflation hedges, such as commodities, gold and real estate, along with some emerging market equities.

 

Gregg Fisher is the founder, head of research and portfolio strategy at Gerstein Fisher, and portfolio manager for Gerstein Fisher Funds. More detail on this subject is available in these two papers: Asset Classes and Inflation (https://bit.ly/2FECNx2) and Commodities and a Diversified Portfolio (https://bit.ly/2Gpghct).

 

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