The combination of loose monetary policy and massive U.S. debt has led to concern about looming inflation. The commonly accepted belief is that a healthy allocation to equities can serve as an inflationary hedge as returns on stocks have far outpaced both bonds and inflation from 1926 to the present – but does this tactic work in the short-term?
To answer that question, and to help you properly set client expectations, we have examined the performance of several different asset classes during a number of short-term inflationary periods (less than five years) dating back to 1936, and what we found doesn’t necessarily harmonize with conventional wisdom. We also thought it worthwhile to examine the pros and cons of investing in relatively newer asset classes such as TIPS and Floating Rate Loans to decide if they warrant an allocation in an inflation-focused portfolio.
To begin, we separated the inflationary periods we examined into two categories: pre-1971 and post-1971 (when the United States officially came off of the gold standard). It’s important to make the distinction between the two as the price of gold remained relatively fixed from 1936-1971 and, as a result, did not behave the same as it does in modern markets. Therefore we did not include gold in the pre-1971 comparison. Instead we focused our study on the performance of 30-day treasury bills, a 50/50 combination of intermediate and long-term government bonds, and large and small cap equities.
The pre-1971 inflationary periods were overall in-line with what most people expect in terms of asset class performance. Government bonds failed to outpace (in 4 out of 5 inflationary periods) while large and small cap equities outperformed inflation in three of five inflationary periods. Figure 1 illustrates these results.
Moving on to the post-1971 category, we examined six different inflationary periods (see Figure 2). It is
important to keep in mind that after interest rates peaked in the latter part of 1981, they began a steady decline to today’s historically low rates. As a result, bonds fared much better during the post-1971 inflationary environments.