Dejan

Investors may wonder whether stock returns will suffer if inflation keeps rising. Here’s some good news: Inflation isn’t necessarily bad news for stocks.

History shows that stocks tend to outpace inflation over time—a valuable reminder for investors concerned that today’s rising prices will make it harder to reach their long-term financial goals.

• A look at equity performance in the past three decades does not show any reliable connection between periods of high (or low) inflation and US stock returns.
• Since 1991, one-year returns on stocks have fluctuated widely. Yet the weakest returns can occur when inflation is low, and 23 of the past 30 years saw positive returns even after adjusting for the impact of inflation. That was the case in the first six months of 2021 too.
• Over the period charted, the S&P 500 posted an average annualized return of 8.5% after adjusting for inflation. The annualized inflation-adjusted return on US stocks is 7.3% when going all the way back to 1926.

1. 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)].
   S&P data © 2021 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved.
2. Based on non-seasonally adjusted 12-month percentage change in Consumer Price Index for All Urban Consumers (CPI-U).
   Source: US Bureau of Labor Statistics.
3. Year-to-date return for 2021 through June 30.

Past performance is no guarantee of future results. Short-term performance results should be considered in connection with longer-term performance results. Investing risks include loss of principal and fluctuating value. There is no guarantee an investment strategy will be successful. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio.

Investment opportunities exist all around the globe, but the randomness of global stock returns makes it exceedingly difficult to figure out which markets are likely to be outperformers. How should investors deal with this kind of uncertainty?

First, they should remember that it’s challenging, at best, to predict a country’s returns by looking at the past, as shown by the performance of global markets since 2001 (see Exhibit 1). In the past 20 years, annual returns in 22 developed markets varied widely from year to year. (Each color represents a different country, and each column is sorted top down, from the highest-performing country to the lowest.)

Two examples help make the point well:

• Austria posted the highest developed markets return in 2017—but the lowest the next year.

• The US ranked in the top five for annualized returns over the entire 20 years but finished first in the country rankings just once over that period. In nine calendar years, it was in the lower half of performers.

Investors can benefit from understanding that they don’t need to predict which countries will deliver the best returns during the next quarter, next year, or next five years. Why? Holding equities from markets around the world—as opposed to those of a few countries or just one—positions investors to potentially capture higher returns where they appear, and outperformance in one market can help offset lower returns elsewhere. Put another way, a globally diversified portfolio can help provide more reliable outcomes over time.

EXHIBIT 1
Most Favored Nations

Past performance is no guarantee of results. In USD. MSCI country indices (net dividends) for each country listed. Does not include Israel, which MSCI classified as an emerging market prior to May 2010. MSCI data © MSCI 2021, all rights reserved.

DISCLOSURES
Diversification neither assures a profit nor guarantees against loss in a declining market. The information in this document is provided in good faith without any warranty and is intended for the recipient’s background information only. It does not constitute investment advice, recommendation, or an offer of any services or products for sale and is not intended to provide a sufficient basis on which to make an investment decision.

RISKS
Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a guarantee of future results. There is no guarantee strategies will be successful.

KEY TAKEAWAYS

• After last year’s economic shocks, we shouldn’t be surprised to see prices rebounding.

• But the potential for inflation is one among many factors investors take into account when agreeing on a price at which to trade.

• A look at headlines from the past 50 years shows the difficulty of timing markets around inflation expectations. Investors may be better served sticking to a long-term plan.

How quickly things change.

Two years ago, the New York Times reported, “Federal Reserve officials are increasingly worried that inflation is too low and could leave the central bank with less room to maneuver in an economic downturn.”¹ More recently, a Wall Street Journal article presented a sharply different view, with a headline that likely touched a raw nerve among investors: “Everything Screams Inflation.” The author, a veteran financial columnist, observed, “We could be at a generational turning point for finance. Politics, economics, international relations, demography and labor are all shifting to supporting inflation.”²

Is inflation headed higher? In the short term, it has already moved that way. With many firms now reporting strong demand for goods and services following the swift collapse in business activity last year, prices are rising—sometimes substantially. Is this a negative? It depends on where one sits in the economic food chain. Airlines are once again enjoying fully booked flights, and many restaurants are struggling to hire cooks and waiters. We should not be surprised that airfares and steak dinners cost more than they did a year ago. Or that stock prices for JetBlue Airways and The Cheesecake Factory surged over 150% from their lows in the spring of 2020.³

Do such price increases signal a coming wave of broad and persistent inflation or just a temporary snapback following the unusually sharp economic downturn in 2020? We simply don’t know. But future inflation is just one of many factors that investors take into account. The market’s job is to take positive information, such as exciting new products, substantial sales gains, and dividend increases, and balance it against negative information, like falling profits, wars, and natural disasters, to arrive at a price every day that both buyers and sellers deem fair.

The future is always uncertain. But willingness to bear uncertainty is the key reason investors have the opportunity for profit.

Let us assume for the moment that rising inflation persists into the future. Some investors might want to hedge against higher inflation, while others might see it as a market-timing signal and make changes to their investment portfolios. But for the market timers to do so successfully, they would need a trading rule that directs exactly when and how to revise the portfolio—“I’ll know it when I see it” is not a strategy. A trading rule based on inflation estimates, however, is just a market-timing strategy dressed in different clothes. A successful effort requires two correct predictions: when to revise the portfolio and when to change it back.

It’s not enough to be negative on the outlook for stocks or bonds in the face of disconcerting information regarding inflation (or anything else). Current prices already reflect such concerns. To justify switching a portfolio, one needs to be even more negative than the average investor. And then outsmart the crowd once again when the time appears right to switch back. Rinse and repeat.

The evidence of success in pursuing such timing strategies—by individuals and professionals alike—is conspicuous by its absence.

To illustrate the problem, imagine it’s New Year’s Day 1979. The broad US stock market⁴ produced a positive return in 1978 but failed to keep pace with inflation for the second year in a row. Your crystal ball informs you that the next two years will see back-to-back double-digit inflation for the first time since World War I.

What would you do? You have painful memories of 1974, when the inflation-adjusted total return for US stocks was –35.05%, among the five worst returns in data going back to 1926.

We suspect many investors would sell stocks in anticipation of significantly lower security prices over the subsequent two years. The result? Most likely a failure to capture above-average returns from both the equity and size dimensions, as shown in Exhibit 1.

EXHIBIT 1

Looking Up

Cumulative return, January 1979–December 1980

Past performance is no guarantee of future results. Indices are not available for direct investment.

Some of the recent concern regarding inflation appears linked to substantial increases in government spending and the US debt load. Determining the appropriate level of each is a contentious public policy issue, and we don’t wish to minimize its importance. But the news items in Exhibit 2 suggest these concerns are not new, and the expected consequences of these issues are likely already reflected in current prices.

The future is always uncertain. But as economist Frank Knight observed 100 years ago, willingness to bear uncertainty is the key reason investors have the opportunity for profit.⁶ Investors will always have something to worry about, and the possibility of unwelcome or unexpected events should be addressed by the portfolio’s initial design rather than by a hasty response to stressful headlines in the future. As recent research from Dimensional highlights, simply staying invested can help investors outpace inflation over the long term.

EXHIBIT 2

Fears Through the Years

US consumer prices were up by 5.4% for the year ending June 2021, the largest annual increase since August 2008.¹ Naturally, inflation is at the center of attention for many US investors.

• Recent Dimensional research suggests that simply staying invested helps outpace inflation over the long term for a wide range of asset classes.

• The protection offered by inflation-indexed securities still appears to be the most effective for investors who are particularly sensitive to unexpected inflation.

• The analysis of data from 1927–2020 covers periods with double-digit US inflation as well as periods with deflation.

Dimensional’s recent paper US Inflation and Global Asset Returns provides some good news for investors looking to outpace inflation over the long term. But it also contains some sobering facts for investors trying to hedge against inflation through alternatives to inflation-indexed securities.

Inflation Outpaced

EXHIBIT 1

Keeping It Real

Average annual real returns in years with above-median US inflation, 1927–2020

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

Inflation Hedged

Despite the reassuring findings presented above, emphasizing growth assets that have historically outpaced inflation may not be appropriate for everyone. If you’re highly sensitive to inflation and have a low tolerance for market risk, you’ll likely want some exposure to inflation-indexed securities (such as TIPS and inflation swaps), and with good reason: they are designed to provide inflation protection. While stocks from certain industries, REITs, commodities, and value stocks are sometimes considered “inflation-sensitive” assets, the data provide little support that they are good inflation hedges.

Nominal asset prices already embed the market’s expectation of inflation. So inflation concerns are really about the negative impact of unexpected inflation on the real value of your invested wealth. An asset is therefore most useful as an inflation hedge when its nominal returns move closely with unexpected inflation. In the paper, Dimensional finds mostly weak correlations between nominal returns and unexpected inflation. For the few exceptions where the correlations are reliable, such as for energy stocks and commodities over 1991–2020, the assets’ nominal returns have been around 20 times as volatile as inflation, and more than half of their nominal-return variation has been unrelated to inflation. Exhibit 2 illustrates this by showing how the annual nominal returns to energy stocks and commodities differ dramatically from the annual realizations of inflation. If the goal is to reduce the variability of future purchasing power, it is questionable that hedging with something this volatile will effectively achieve that.

EXHIBIT 2

One of These Things Isn’t Like the Others

Annual US inflation along with nominal returns to energy stocks and commodities, 1991–2020

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

Inflation Deflated

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. Fortunately, we don’t need a crystal ball to address inflation in our portfolios. The data suggest that simply staying invested helps outpace inflation over the long term. And for those of us who are particularly sensitive to unexpected inflation, the protection offered by inflation-indexed securities still appears to be the most effective.

 

FOOTNOTES

1. ¹Based on the US Consumer Price Index for All Urban Consumers (CPI-U, not seasonally adjusted) from the Bureau of Labor Statistics.

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

GLOSSARY

T-bills: Short-term debt issued by the US Treasury Department.

Treasury Inflation-Protected Securities (TIPS): Bonds issued by the US Treasury Department that provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, the investor is paid the adjusted principal or original principal, whichever is greater.

Inflation swaps: An inflation-swap agreement is a two-sided contract in which one party receives floating payments tied to the actual inflation rate and pays fixed payments based on expected inflation and the inflation risk premium for a given notional amount and period.

Nominal return: The rate of return on an investment without adjusting for inflation.

Real return: The rate of return on an investment after adjusting for inflation.

RISKS

Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a guarantee of future results. There is no guarantee strategies will be successful.

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.

DISCLOSURES

Eugene Fama and Ken French are members of the Board of Directors of the general partner of, and provide consulting services to, Dimensional Fund Advisors LP.

The information in this document is provided in good faith without any warranty and is intended for the recipient’s background information only. It does not constitute investment advice, recommendation, or an offer of any services or products for sale and is not intended to provide a sufficient basis on which to make an investment decision. It is the responsibility of any persons wishing to make a purchase to inform themselves of and observe all applicable laws and regulations. Unauthorized copying, reproducing, duplicating, or transmitting of this document are strictly prohibited. Dimensional accepts no responsibility for loss arising from the use of the information contained herein.

“Dimensional” refers to the Dimensional separate but affiliated entities generally, rather than to one particular entity. These entities are Dimensional Fund Advisors LP, Dimensional Fund Advisors Ltd., Dimensional Ireland Limited, DFA Australia Limited, Dimensional Fund Advisors Canada ULC, Dimensional Fund Advisors Pte. Ltd., Dimensional Japan Ltd., and Dimensional Hong Kong Limited. Dimensional Hong Kong Limited is licensed by the Securities and Futures Commission to conduct Type 1 (dealing in securities) regulated activities only and does not provide asset management services.