CLIENT QUESTION OF THE MONTH - What Should I Be Doing About Inflation?

It may be an understatement to say that inflation is a popular subject. The Consumer Price Index was up 7.1% in December from the year prior1.

Prices include expectations for inflation. On average, hundreds of billions of dollars of treasury bonds are traded daily2. Market participants incorporate their expectations around future inflation into their trades. As new information develops, they may reassess their expectations.

While the market is making its best estimate of inflation, there is a risk that those expectations are wrong. Because of that, the market will demand a premium for bearing the risk of unexpected inflation; this premium is reflected in the price of nominal bonds (bonds that aren’t inflation-protected).

Some investments touted as “inflation-sensitive,” may not behave the way investors are hoping. While some of these assets may have evidence of correlation, such as energy stocks and commodities, the assets’ nominal returns have been around 20 times as volatile as inflation3. This volatility may not be best suited for investors concerned about the variability of their purchasing power.

History shows us that stocks have outperformed inflation over time. Over the past three decades through June 2021, the S&P 500 had an annualized return of 8.5% after adjusting for inflation4. Dimensional’s recent article Will Inflation Hurt Stock Returns? Not Necessarily explores how in that time, there was not a reliable connection between periods of high inflation and stock returns.

But what about periods with double digit inflation, like the 1940s and 70s? We find similar results going back to 1927 through 2020. Exhibit 1 shows the real returns in years with above average inflation (5.5%) of asset classes ranging from various bonds, stocks, sectors, and even equity premiums. Each of these assets outpaced inflation except for T-Bills4. (T-Bills are short- term debt issued and backed by the full faith and credit of the US government.)

For investors who are sensitive to unexpected inflation, there are options available. One option, Treasury Inflation-Protected Securities (TIPS), are linked to changes in consumer price. An alternative is buying short-duration corporate bonds while using inflation swaps to protect against rising prices. This strategy involves more credit risk but offers higher expected returns and allows greater diversification relative to TIPS.

The best answer to the question "What should I be doing about inflation?" may be boring. History shows that stocks tend to outpace inflation over the long term—a valuable reminder for investors concerned that today’s rising prices will make it harder to reach their financial goals. What will next month’s inflation reading be? How will it compare to market expectations? Is the rise in inflation temporary or long-lived? Nobody has a crystal ball, but the data suggests that simply staying invested helps outpace inflation over the long term.

Source: https://my.dimensional.com/are-concerns-about-inflation-inflated

Returns are in US dollars. See the “Data Appendix” for additional information. Past performance is no guarantee of future results. Indices are not available for direct investment.

 1 Source: Federal Reserve Bank of St. Louis, https://fred.stlouisfed.org/series/CPIAUCSL

2 In US dollars. Source: SIFMA, data for 2020.

3 Source: Dimensional Fund Advisors, Are Concerns About Inflation Inflated?

4 Source: US Bureau of Labor Statistics, S&P data © 2021 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Based on non-seasonally adjusted 12-month percentage change in Consumer Price Index for All Urban Consumers (CPI-U).

Diversification neither assures a profit nor guarantees against a loss in a declining market. Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, liquidity, prepayments, call risk, and other factors. Inflation-protected securities may react differently from other debt securities to changes in interest rates.

Data Appendix

Real returns illustrate the effect of inflation on an investment return and are calculated using the following method: [(1 + nominal return of index over time period) / (1 + inflation rate)]

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: https://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html