KEY TAKEAWAYS
- Recent academic-level research indicates that a globally diversified and structured investment strategy based on an array of assets classes would outpace long-term inflationary effects.
- The protection offered by inflation-indexed securities appears to be the most effective for fixed-income allocation strategies designed to be sensitive to unexpected inflation.
- The 1927–2020 study examined both double-digit and deflationary U.S. inflation periods.
US consumer prices were up by 5.4% for the year ending June 2021, the largest annual increase since August 2008.1 Naturally, inflation has gained much media attention and consequently that of ordinary Americans who’ve notice recent price increases in daily shopping and house prices.
Dimensional Fund Advisor’s recent paper “US Inflation and Global Asset Returns”2 provides good news for those planning retirement strategies intended to outpace long term inflationary price increases in services and goods. The study also contains sobering facts for those who believe that inflation may be hedged using so-called “alternatives.” Maintaining an informed globally diversified strategy is more likely to outpace long-term inflation, data suggest, and inflation-index securities can better complement an effective inflation-protected approach for successful long-term planning outcomes.
Inflation Outpaced
Exhibit 1 from the study shows average real returns (that is, returns net of inflation) for different asset classes in years with high (above-median) inflation from 1927 to 2020. The study considers a total of 23 U.S. assets that span bonds, stocks, industries, and underlying equity premiums. Over this period, inflation averaged 5.5% per year in “high-inflation” years. While average real returns (rather than nominal return figures having the illusion of greater returns) were mostly lower in high inflation years compared to years with low inflation, the exhibit shows that all assets except one-month T-bills — U.S. government short-term debt — had positive average real returns.
The analysis covering 1927–2020 is useful because it examines periods with double-digit US inflation (like the 1940s and ’70s) as well as periods with price deflation (like the Great Depression, 1929–32). The study found similar results over the recent 30-year period (1991–2020), when U.S. inflation was relatively mild and prices relatively stable. The recent period included expanded analysis including non-USD bonds, developed- and emerging-market equities, real estate investment trusts (REITs), and commodities. Overall, outpacing inflation long term has been the rule rather than the exception for common investment asset classes.
Exhibit 1: Keeping It Real
Average annual real returns in years with above-median US inflation, 1927–2020
Source: Dimensional Fund Advisors. See Data Appendix below and links to the study for more information. Past performance is no guarantee of future results. Indices are not available for direct investment.
Inflation Risk, Hedged
Despite reassuring findings, disproportionately allocating to popular growth assets (selected based on recent past relative performance) would not be appropriate for most investors. Retirees and others sensitive to inflationary effects with a continuing need for reliable income and likely to have a lower tolerance for market volatility, should allocate greater exposure to inflation-indexed securities (such as TIPS and inflation swaps) specifically managed to provide inflation protection. While stocks from certain industries, REITs, commodities, and value stocks may be promoted by some as “inflation-sensitive,” the evidence does not show that they are reliable inflation hedges for informed planning applications.
Nominal asset prices on which investors based their purchases already embed the market’s current expectation of inflation. So investor inflation concerns really should be about the negative impact of unexpected inflation on the real value of your wealth. A true inflation “hedge” will have its nominal returns closely aligned with unexpected inflation. The study importantly showed only weak correlations between nominal returns and unexpected inflation. Exceptions included energy stocks and commodities, but their nominal returns were around 20 times as volatile as inflation, as many other factors impact their pricing. Exhibit 2 shows how widely their nominal returns often differ from actual inflation.
Exhibit 2: Deflating Inflation “Solutions”
Annual US inflation along with nominal returns to energy stocks and commodities, 1991–2020
Source: Dimensional Fund Advisors. See Data Appendix below and links to the study for more information. Past performance is no guarantee of future results. Indices are not available for direct investment.
Inflation Severity Deflated
What will next month’s or next year’s reading of inflation be? Is the current rise in inflation temporary as government officials claim or stubbornly long-lived? Nobody has a crystal ball. Fortunately, you don’t need a crystal ball to effectively address the impact of expected or unexpected inflation with an informed portfolio strategy. Staying invested with a dimensionally allocated strategy based on financial science and decades of academic evidence, skillfully managed, will likely outpace inflation for long-term planning purposes. Whether you save enough or spend prudently for your goals depends entirely on you and your personal situation.
For those of you particularly sensitive to the impact of unexpected inflation for planning retirement income, incorporating longer-dated inflation-indexed income strategies in coordination with techniques like reverse mortgages and long-term care insurance for flexibility in spending due to idiosyncratic risks mostly related to health, would likely be the most successful long-term inflation “hedge” to incorporate for planning to protect your lifestyle and financial security.
FOOTNOTES
1.Based on the US Consumer Price Index for All Urban Consumers (CPI-U, not seasonally adjusted) from the Bureau of Labor Statistics.
2.Dai, Wei and Medhat, Mamdouh, US Inflation and Global Asset Returns (July 13, 2021). Available at SSRN here.
DATA APPENDIX
US inflation
The annual rate of change in the Consumer Price Index for All Urban Consumers (CPI-U, not seasonally adjusted) from the Bureau of Labor Statistics.
US government securities and long-term corporate bonds
The returns to US government securities (one-month T-bills, five-year notes, and long-term bonds) and long-term corporate bonds are from Morningstar (previously from Ibbotson Associates).
US equity portfolios and factors
The US equity market is proxied by the Fama/French Total US Market Research Index. The US industry portfolios are the 12 Fama/French industry portfolios. The US style portfolios (small cap value and growth and large cap value and growth) are from the Fama/French six portfolios sorted on size (market cap) and book-to-market equity. The US size and value premiums are proxied by the Fama/French size and value factors. The returns to all of the above are from Ken French’s data library here.