Investors need to understand how the tools they use to fight inflation work—and don’t work, Swedroe says.
One of the important objectives of investment strategy is protecting the portfolio from the negative impacts of unexpected inflation, and the best tool to hedge against inflation is TIPS, Treasury inflation-protected securities.
However, because equities have outpaced inflation by significant margins over the long term, many investors consider equities to be good inflation hedges. There are two problems with that line of thinking. The first is that high returns are accompanied by high risk. Many investors either aren’t able to accept the risks of stocks and/or are unwilling to do so because they have low levels of risk tolerance—which is to say they are highly averse to losses.
A second problem is that a high overall average return doesn’t imply that stocks will perform well during periods of high inflation. To be an effective hedge against inflation, an asset should have high returns when inflation is high.
Wes Crill and Jim Davis of Dimensional Fund Advisors (DFA) examined the relationship between U.S. inflation and the returns on global stock and bond indexes from 1960 through 2012. (Full disclosure: My firm, Buckingham, recommends DFA funds in the construction of client portfolios.) The authors split the data between the 26 years of relatively low inflation and the 27 years of relatively high inflation. The following is a summary of the findings of their paper “U.S. Inflation and the Returns in Global Stock and Bond Markets.”
The authors found that during the 26 years of relatively low inflation, Treasury bills provided a real return of 1.0 percent, almost identical to the 1.1 percent real return in the 27 years of relatively high inflation. For U.S. bonds, the real return during the low-inflation years averaged 5.1 percent.
In those same years. international bonds averaged a real return of 8.1 percent. Even during the 27 years of higher inflation, U.S. bonds still provided a real return of 2.1 percent, and international bonds provided a real return of 3.0 percent. If inflation is high, but expected, it shouldn’t have a negative impact on bond returns, as expected inflation is built into yields.
For the 26 years of relatively low inflation, U.S. stocks averaged a real return of 10.7 percent, while international stocks averaged a real return of 8.8 percent. For the high inflation years, the real returns to both were much lower—3.5 percent for U.S. stocks and 6.0 for international stocks.
The evidence demonstrates that global stocks and bonds have provided investors with positive real growth during periods of both high and low U.S. inflation. The evidence also suggests that holding both unhedged international bonds and international stocks during periods of high U.S. inflation does provide some diversification benefits, providing further evidence on the benefits of international diversification.
Crill and Davis also examined the data to see the impact of unexpected inflation on returns. They found that U.S. Treasury bill returns have been positively related to both expected and unexpected inflation. On the other hand, as we should expect, returns to U.S. bonds have been negatively related to unexpected inflation. U.S. stock returns are positively correlated with expected inflation but negatively correlated with unexpected inflation.
The reverse was true for unhedged international stocks and bonds. Their returns were negatively correlated with expected U.S. inflation and positively correlated with unexpected U.S. inflation—though the correlations were weak and not statistically significant.
The authors also concluded that since Treasury bills have only provided a partial hedge against unexpected inflation, investors who have a low tolerance for unexpected inflation should consider an allocation to TIPS.
Larry Swedroe is director of Research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.