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Why inflation matters

Even low inflation can erode your portfolio’s purchasing power. Learn what you can do.

  • By Dirk Hofschire, CFA, SVP, Asset Allocation Research, Kathryn Carlson, Research Analyst, Joanna Bewick, CFA, Portfolio Manager,
  • Asset Management
  • – 11/20/2013
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At 2%, our long-term inflation forecast appears fairly non-threatening, but there are two important reasons why managing inflation risk still matters.

First, inflation erodes the purchasing power of a portfolio’s value. For example, if the inflation rate was at its historical long-term average of 3% over a 10-year period, the original value of $100 would fall by 26% to only $74. Second, stocks and bonds typically perform less well during periods of high and rising inflation. As a result, unexpected inflation represents a risk to the performance of traditional portfolio allocations, and managing that risk should be incorporated into an investment strategy.

Of course, the inflation risk you experience depends on personal factors. For instance, a retiree living on a fixed pension with expenses concentrated in health care, where costs are with rising rapidly, may face a much higher implicit inflation rate and higher inflation risk than an average investor.

In contrast, a young investor with growing employment income who spends more on technology—a sector where input costs continue to decline—may experience a lower implicit inflation rate and less inflation risk. So, inflation considerations should be tailored to your particular circumstances.

Our inflation outlook

An economy has many potential inflation drivers that can be grouped into three general categories: health of the jobs market, shocks such as changes in the price of oil and big fluctuations in the dollar exchange rate, and monetary policy and inflation expectations (see the chart right). Forecasting the impact of these key factors is crucial to creating an inflation outlook.

We think inflation will be range-bound over the next 12 to 18 months. Core inflationary pressures are experiencing modest upward pressure from income growth and the pickup in housing, offsetting the disinflationary impact of a stronger dollar and lower import prices. Oil prices—particularly if driven by a supply shock—are a major wild card for short-term inflation measures, but oil-driven inflation spikes tend to be more transient, and create a disinflationary impact on other parts of the U.S. economy.

Inflation-resistant assets

What if inflation does heat up? Most financial assets, including the majority of stocks and bonds, tend to underperform their historical averages during an inflationary environment.

Rising inflation expectations generally lead to higher interest rates and discount rates. Therefore, high quality fixed-rate bonds perform the worst in periods of rising inflation, because the fixed cash flows are discounted at a higher rate. In terms of cash holdings, their short maturities make them less sensitive to inflation, because investors can roll these assets over more frequently and participate in higher rates. Finally, while stocks may enjoy a positive offset when rising inflation increases company revenues, inflation can also impair stock valuations when higher rates are used to discount company earnings.

However, two broad asset categories have historically tended to hold up relatively well during inflationary climates: real assets and financial securities with features that enable them to adapt positively to inflation (see the chart below, right).

Commodities are an example of real assets, such as oil and copper. Their prices tend to rise when mounting demand is stoking broad inflation or when negative supply shocks cause oil or food prices to spike. Investors should note the relatively high volatility associated with commodities. One means of offsetting their volatility is to invest in a diversified basket of commodity exposures.

Another source of real assets is commercial real estate— apartment buildings, office towers, and shopping malls. Investors can gain exposure to these assets through real estate investment trusts (REITs) and real estate fixed income. Within this segment, combining equities that offer the potential for outperforming the stock market with bonds that have defensive characteristics can benefit an asset allocation that is attentive to inflation hedging.

REITs maintain value during inflationary periods because they generally own physical structures and property that generate rents, which can be increased as broad prices rise. REITs tend to be less influenced by rising inflation than paper-based monetary assets. However, it is a sector that can be prone to volatility. As such, significant research is a necessary prerequisite to maximizing the reward per unit of risk in real estate.

Within the fixed income market, Treasury Inflation-Protected Securities (TIPS) and leveraged loans provide returns that adjust for inflation. TIPS are Treasury bonds whose principal value is adjusted daily based on lagged Consumer Price Index moves. While TIPS have a constant coupon rate, the security generates a higher level of interest when the inflation-adjusted principal rises, thus protecting the investor against inflation. The inflation-adjusted principal value of TIPS is paid at maturity.

Leveraged loans are floating-rate bank loans to companies with below-investment-grade (high yield) credit quality. These loans provide a coupon—typically three-month LIBOR1 plus an additional yield spread to compensate for higher credit risk. As LIBOR rises or falls, the coupon automatically adjusts to movements in short-term interest rates, meaning income rises as short-term rates increase. Because interest rates typically tend to rise as inflationary pressures pick up, the floating rate mechanics make leveraged loans an effective inflation offset.

Inflation considerations and portfolio construction

In isolation, commodities, real estate, TIPS, and floating-rate loans have qualities that make them inflation resistant when investors need it most—when inflation is rising. Our research shows that commodities, TIPS, and leveraged loans have outpaced inflation more than 80% of the time during periods of rising inflation. A composite portfolio of inflation-resistant asset categories beat inflation nearly 90% of the time. 2

What’s more, these assets have relatively low correlations with each other and stocks and bonds (see the chart below), meaning they can offer diversification opportunities to a traditional portfolio. This is important because a portfolio’s inflation-resistant qualities can be bolstered without compromising the risk-return profile of a portfolio. Therefore, a diversified approach to protecting against the impact of inflation can be more effective than investing in any of the single asset classes discussed.

Of course, the degree of inflation hedging an investor achieves by owning inflation-resistant assets will be influenced by the timing and pricing of their purchases. Adding such assets at reasonable valuations over time would help investors avoid chasing these assets at higher prices when inflation accelerates.

Investment implications

For certain types of investors with income streams that are fixed, inflation can present a significant hurdle. Therefore, inflation protection is a critical component of an investment plan.

Investing in inflation-sensitive assets such as TIPS, leveraged loans, commodities, REITs, and real estate fixed income offers the opportunity to preserve purchasing power and provides a potential hedge against an unexpected rise in inflation.

While these assets provide inflation resistant characteristics on their own, a diversified approach to inflation hedging may be more effective than investing in any single asset class. A diversified portfolio approach can provide exposure to categories with higher inflation resistance, such as commodities and real estate, without assuming their commensurate volatility.

Learn more

  • Read the full report on why inflation matters.
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In general the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so avoiding losses caused by price volatility by holding them until maturity is not possible.
Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments.
Changes in real estate values or economic conditions can have a positive or negative effect on issuers in the real estate industry, which may affect the fund.
Increases in real interest rates can cause the price of inflation-protected debt securities to decrease.
Leveraged loans inherently have higher refinancing/repricing risk. Unlike other credit investments with non-call periods when the bonds cannot be redeemed, leveraged loans are callable at par at any time. As the broader market trades above the long-term average price and some loans trade at or above par, this callability presents an additional downside risk to loan investors.
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Thus, hypothetical performance is speculative and of extremely limited use to any investor and should not be relied upon in any way.
Hypothetical performance of the model is no guarantee of future results.
1. London Interbank Offered Rate.
2. Composite portfolio made up of 30% TIPS, 25% commodities, 25% leveraged loans, 10% REITs, and 10% real estate debt.
S&P GSCI Commodities Index encompasses the principal physical commodities that are traded in active, liquid futures markets.
Dow Jones-UBS Commodities Index is a broadly diversified index that encompasses futures contracts on physical commodities.
Real Estate Investment Trusts (REITs)
FTSE NAREIT All Equity Index contains all tax-qualified REITs with more than 50% of total assets in qualifying real estate assets other than mortgages secured by real property.
The Dow Jones U.S. Select Real Estate Securities Index includes equity real estate investment trusts (REITs) and real estate operating companies traded in the U.S.
Third-party marks are the property of their respective owners; all other marks are the property of FMR LLC.
The Consumer Price Index (CPI) measures over time the cost of goods and services purchased by the consumer compared to a base period.
Money velocity = GDP/M2. GDP = Gross domestic product. M2 = money supply measure including currency, demand deposits, checking deposits, savings accounts, money market accounts, certificates of deposit. Monetary base = currency plus reserves in the banking sources.
The efficient frontier is at the core of modern portfolio theory. It represents those portfolios with the highest expected return for a given level of risk.
Standard deviation indicates the volatility of data over time. A higher standard deviation indicates a wider dispersion of past returns and thus greater historical volatility.
Index definitions
The IA SBBI U.S. Intermediate-Term Government Bond Index is an unweighted index that measures the performance of five-year maturity U.S. Treasury bonds. Each year a one-bond portfolio containing the shortest non-callable bond having a maturity of not less than five years is constructed.
The IA SBBI U.S. Long-Term Corporate Bond Index is a custom index designed to measure the performance of long-term U.S. corporate bonds.
Barclays U.S. Aggregate Bond Index is an unmanaged, market valueweighted performance benchmark for investment-grade fixed-rate debt issues, including government, corporate, asset-backed, and mortgagebacked securities with maturities of at least one year.
Barclays U.S. Treasury Inflation-Protected Securities (TIPS) Index is a market-value-weighted index that tracks inflation-protected securities issued by the U.S. Treasury.
The IA SBBI U.S. 30 Day Treasury Bill Index is a custom index designed to measure the performance of 30-day Treasury bills.
Real Estate Fixed Income
BofA ML Corporate Real Estate Index, a subset of BofA Merrill Lynch U.S. Corporate Index, is a market-capitalization-weighted index of U.S. dollar– denominated investment-grade corporate debt publicly issued in the U.S. domestic market by real estate issuers. Qualifying securities must have an investment-grade rating (based on an average of Moody’s, S&P, and Fitch). In addition, qualifying securities must have at least one year remaining to final maturity, a fixed coupon schedule, and a minimum amount outstanding of $250 million.
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Leveraged loans
S&P/LSTA Leveraged Performing Loan Index (Standard & Poor’s/Loan Syndications and Trading Association Leveraged Performing Loan Index) is a market-value-weighted index designed to represent the performance of U.S. dollar–denominated, institutional leveraged performing loan portfolios (excluding loans in payment default) using current market weightings, spreads, and interest payments.
CSFB Leveraged Loans index represents tradable, senior-secured, U.S.- dollar non-investment grade loans.
CSFB Leveraged Loan Index measures tradable, senior-secured, U.S. dollar–denominated non-investment-grade loans.
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