Keeping it Real

Stories and headlines driving the markets both higher and lower seem to be accelerating over the last few months:

The war in Eastern Europe continues to make news as it enters the sixth week since the conflict started.

The Federal Reserve announced the first interest rate hike after the policy actions taken to combat the pandemic in 2020.
Inflation data continues to come in higher than expected, not just in the US but in many other developed nations, which puts pressure on bond prices and yields throughout the globe.

We could spend many paragraphs discussing these headline-making topics and many others, but today we wanted to focus on inflation. What does it mean for portfolios, and if we can gain an insight into how markets have behaved in periods with above average inflation over the last nine decades.

Specifically, what interests us is the real return that various assets have experienced during periods of higher than average inflation. Think of real return as the actual return of an asset after you subtract inflation. So when inflation is 7%, and an asset returns 10%, the real return is 3%. A clear picture starts to emerge if we analyze asset returns during these periods.

Looking at this chart, it becomes obvious that one place where investors can’t seem to hide and have historically earned a negative real return is in T-Bills. This makes sense intuitively as T-Bills would be a lagging way for the policymakers at the Federal Reserve to control inflation. As inflation has gone higher, it takes time to adjust T-Bills to higher rates, and thus they will likely fall behind. Bonds, whether short or long-term, have experienced positive real returns. While the equity components are broken down into various sectors, all have experienced positive real returns in this environment, from energy to manufacturing companies. A more concise chart of the above sectors is shown below.

Given the past performance of various assets classes during above-average periods of inflation, is there anything that investors need to consider adding to their portfolio to protect against a prolonged period of inflation?

Rather than trying to pick which sector may perform best during a period of higher than average inflation, investors should focus on owning all the segments of the market. We have built our portfolios with a globally diversified allocation of stocks, short-term and intermediate-term fixed income, and an allocation towards real assets, including REIT’s and inflation-protected bonds. These portfolio are then stress tested for periods of higher and lower returns, which include periods where inflation is both higher and lower.

As noted above in the chart, simply staying invested helps outpace inflation over the long term for a wide range of asset classes. We will continue to review portfolios as markets continue to digest the news of the day and look for opportunities to rebalance into out favor assets if and when those opportunities present themselves in the future.