How to manage inflation

If inflation picks up, it can have an impact on a wide range of investments.

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Key takeaways

  • Any inflation erodes the purchasing power of portfolios.
  • Rising inflation has historically been a drag on inflation-adjusted stock and bond returns, making diversification beyond mainstream asset classes more important.
  • Conservatively positioned, income-oriented retirees tend to be more exposed to inflation risk than more aggressively positioned young workers.
  • A strategic allocation to a mix of inflation-resistant assets—including commodities, gold, commodity-linked stocks, and short-duration bonds—may help investors manage these risks.

After more than 35 years of generally falling inflation, signs of an uptick have unnerved investors. Among the factors that could drive prices higher: strong global growth, rising interest rates, and peak globalization.

What does inflation mean for investors?

If inflation does pick up, it could have an impact on a wide range of investments. This is why inflation warrants prudent risk management, particularly for retirees or more conservative investors.

3 key reasons to consider inflation risk

1. Inflation erodes purchasing power

Inflation impedes a portfolio's purchasing power over time. For example, if over the next 10 years inflation continues to average 2.2% (which it has for more than 25 years), the purchasing power of $100 would fall by 20%, to just $80 by 2027. The inflation rate might therefore be considered the "hurdle rate" for an investment strategy—the minimum return required to keep a portfolio's purchasing power intact. In other words, inflation does not need to be high or rising to represent a risk to an investment strategy; it should be a key consideration for managing portfolio risk in any scenario.

2. Rising inflation has historically been a drag on stock and bond returns

Stocks and bonds do not historically perform as well during periods when inflation is rising for an extended period of time (at least 6 months). During such inflationary periods since the mid-1930s, the magnitude of stock performance on a real (inflation-adjusted) basis has fallen and the real return of intermediate Treasuries, on average, has been slightly negative (see chart).

Even if the highly inflationary 1970s are excluded from the analysis, the real annualized returns for US equities and 10-year Treasuries have been just 1% and 0.4%, respectively, during periods of rising inflation—well below their long-term averages of roughly 7% and 2%. On the other hand, during periods when inflation has sustainably fallen, real returns for both stocks and bonds have tended to improve significantly, and the magnitude to which stocks outperformed bonds also tended to be higher.

Although inflation may provide a boost to stocks by increasing company revenues, it can also impair valuations when higher rates are used to discount earnings. Increasing revenues may also be offset by simultaneous increases in costs. For high-quality bonds—such as Treasuries—performance tends to deteriorate when inflation rises, because their fixed cash flows are discounted at a higher rate.

3. Higher inflation makes diversifying beyond mainstream asset classes more essential

History suggests that the correlation between stocks and bonds is heavily dependent on inflation and economic growth. For the past 20-plus years, inflation has been generally low and stable, leaving growth to have a greater impact on correlations (see chart, below). Stock performance is positively tied to changes in growth expectations, while bond performance is negatively correlated to growth expectations. Therefore, bond returns tend to have a low or even negative correlation with stock returns when inflation is low.

By contrast, when inflation is higher and more volatile—as it was in the 1970s—the correlation between stocks and bonds increases. Because rising inflation negatively affects the performance of both stocks and bonds, bonds generally become more equity-like amid higher inflation and thus tend to provide less diversification. One of the few diversifiers for stocks in these periods has historically been inflation-resistant assets, such as commodities.

Investors may be able to mitigate inflation risks

Although the performance of the major asset classes tends to deteriorate when inflation is on the rise, 2 asset-class subcategories have historically held up better in such environments.

The first subcategory contains asset classes with long histories of reliable returns that, on average, outperform when inflation is rising:

  • Commodities: Commodity prices tend to rise when mounting demand stokes broad inflation or when negative supply shocks cause oil or food prices to spike.
  • Gold: Gold has historically been viewed as a store of value relative to paper currencies, which tend to lose value when inflation rises.
  • Commodity-producing equities: These companies, such as those in the energy and materials sectors, benefit from the same trends as commodities, and have the ability to use operational and financial leverage to further magnify the positive impact of rising prices on earnings growth.
  • Short-duration bonds: These bonds (including T-bills) have short maturities that make them less sensitive to inflation because investors can roll them over more frequently and participate in higher rates.

The second subcategory consists of other asset classes with shorter histories of returns that make long-term analysis more difficult. However, our analysis suggests that their underlying properties would have also provided them with more resistance against rising inflation over the long term than the major asset classes.

  • Real estate investment trusts (REITs): REITs tend to hold their value when inflation rises because they generally own physical structures that generate rents, which can be increased as prices rise.
  • Treasury inflation-protected securities (TIPS): TIPS are Treasuries with principal values that adjust based on moves in the consumer price index, providing a hedge against rising inflation.
  • Leveraged loans: Leveraged loans are floating-rate bank loans to companies with below-investment-grade (high-yield) credit quality. The coupons on these loans adjust to movements in short-term interest rates, so if short-term rates rise, so will the coupon rates (for example, when inflation is rising).

Although these asset categories have trailed the broader stock and bond markets amid falling inflation, they’ve outperformed when inflation has risen (see chart, below).

Individual inflation-resistant assets do not respond equally to inflation

Rising inflation can come in many forms, and inflation-resistant assets don’t necessarily respond equally to all of them. For example, during inflationary periods in the 1960s, commodities outperformed the equity market, while energy companies underperformed. In the 1980s, though, energy companies outperformed, while commodities underperformed. Ultimately, there is no single asset class that has consistently outperformed in every inflationary environment. Therefore, a strategic allocation to a mix of inflation-resistant asset classes may be a sensible approach.

The chart at the right shows one example of a multi-asset-class allocation to inflation-resistant assets versus more traditional portfolio allocations. The “inflation portfolio” has an equal weighting of commodities, gold, energy stocks, materials stocks, and T-bills. These asset classes were chosen as samples of the broader inflation-resistant asset universe because they have long histories of reliable data. While such a basket has historically been a drag on returns during disinflationary periods, it has provided increased inflation protection when investors have needed it most.

Inflation risks matter for everyone, but for some investors more than others

Inflation risk confronts every investor, but it can vary significantly from one individual or strategy to the next due to a number of factors. Four key considerations include an investor’s time horizon, relevant inflation rate, starting allocation, and the nature of the required income stream (whether it’s fixed or rising). Therefore, inflation considerations should be tailored to the individual investor or investment strategy.

For instance, consider an investor who is retired, living on a fixed income stream, who may have more expenses concentrated in health care (where costs are rapidly rising), and whose portfolio is conservatively positioned with 20% in stocks and 80% in bonds. This income-oriented retiree may face a higher effective inflation rate than average and earn a lower average portfolio return, and therefore may be more exposed to a sustained rise in inflation.

By contrast, consider a young worker with a long time horizon to save for retirement, expectations of growing employment income over time, and an aggressive portfolio allocation of 80% stocks and 20% bonds. The young worker may face a lower effective inflation rate and earn a higher average portfolio return, and thus may be less exposed to a sustained rise in inflation.

To illustrate how these risks may play out for different types of investors and strategies, consider how inflation affected performance in the most extreme historic example of high and rising inflation—the late 1960s and 1970s.

During this period, real returns for both conservatively positioned, income-oriented retired investors and more aggressively positioned young workers were subpar (see chart, below). While the young worker’s portfolio performance still modestly outpaced inflation, the more conservative retired investor experienced negative real returns on average for 16 consecutive years.

The 1970s were clearly an extreme example of high inflation and might be considered a worst-case scenario for inflation risk. But as we’ve shown, periods of modestly rising inflation still pose challenges for mainstream asset classes. Ultimately, rising inflation will likely be more damaging for the income-oriented retiree due to the other key considerations discussed earlier. The purchasing power of the fixed income stream deteriorates, the investor has less ability to recoup purchasing power because of the shorter investment horizon and more conservative allocation, and the investor’s potentially higher effective inflation rate (due to greater exposure to health care costs) tends to make any shortfall more painful.

How to consider a strategic allocation to inflation-resistant assets

While the proper allocation to inflation-resistant assets is highly dependent on each investor’s unique circumstances and investment strategy, the table above illustrates a 10% strategic allocation, sourced equally (5%) from both the stock and bond portions of the existing portfolios. In this example, the “inflation portfolio” improved the average real returns of both the conservatively positioned income-oriented retiree’s and the young worker’s portfolios by 0.7 percentage points per year during the extremely inflationary period from 1965 to 1980.

It is important to note, however, that holding a strategic allocation to inflation-resistant assets during the long periods of generally slowing inflation from 1981 to 2015 modestly detracted from performance in this example. And it is extremely difficult to accurately predict changes in the rate of inflation. What's more, there are a number of ways to manage inflation risk, and adding a mix of inflation-resistant assets to a portfolio is just one option. You may want to simply consider a higher allocation to stocks, though that would come with greater market risk. You might want to consider covering your essential expenses with guaranteed income sources that have inflation protection, for instance a lifetime annuity with an inflation rider.* Determining the most appropriate way to manage inflation risk will therefore be highly dependent on both the perceived risk of higher inflation and the key considerations unique to each investor and investment strategy.

Inflation risks warrant prudent risk management

As we’ve discussed, any inflation erodes a portfolio’s purchasing power over time. Moreover, a sustained move toward higher inflation is a risk to most investors and investment strategies, given that rising inflation has historically been a drag on equity and bond returns, making diversification beyond mainstream asset classes more critical. Therefore, inflation risk should be a consideration of any investment strategy.

These risks are ultimately more concerning, however, for conservatively positioned, income-oriented retired investors who are less likely to recoup losses in purchasing power due to shorter investment time horizons. A strategic allocation to a basket of inflation-resistant assets, such as commodities, commodity-producing equities, gold, short-duration bonds, and possibly REITs, TIPS, and/or leveraged loans, may help these investors manage the risk that inflation could be higher than anticipated over the long term.

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Authors
Austin Litvak, Senior Analyst, Asset Allocation Research; Dirk Hofschire, CFA, Senior Vice President,Asset Allocation Research; Irina Tytell, PhD l Senior Research Analyst, Asset Allocation Research; Ilan Kolet, Research Analyst, Asset Allocation Research
The Asset Allocation Research Team (AART) conducts economic, fundamental, and quantitative research to develop asset allocation recommendations for Fidelity’s portfolio managers and investment teams. AART is responsible for analyzing and synthesizing investment perspectives across Fidelity’s asset management unit to generate insights on macroeconomic and financial market trends and their implications for asset allocation.
Fidelity Thought Leadership Director Christie Myers provided editorial direction for this article.
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Index definitions
Bloomberg Barclays U.S. 1-3 Month Treasury Bill Index includes all publicly issued zero-coupon U.S. Treasury Bills that have a remaining maturity of less than 3 months and more than 1 month, are rated investment grade, and have $250 million or more of outstanding face value. In addition, the securities must be denominated in U.S. dollars and must be fixed rate and non-convertible.
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