Content Courtesy of Dimensional Fund Advisors
By Gerard O'Reilly, PhD Co-Chief Executive Officer and Chief Investment Officer (no connection to O’Reilly Wealth Advisors - just a great Irish name)
Trying to outguess financial markets on the outlook for inflation is futile. Investors are better off using market gauges of consumer price expectations and focusing instead on how to outpace, or hedge against, the harmful effects on future spending that such measures imply.
The past three decades have been a period of relatively moderate inflation in the United States with the annual increase in the consumer price index averaging around 2.3%. Yet the impact of even this amount of inflation has been to reduce the purchasing power of an uninvested dollar by around half. It therefore matters a lot whether the recent pickup in the pace of price rises is transitory, as Federal Reserve Chairman Jerome Powell predicts, or more enduring.
The collective best guess of investors as aggregated by market prices is hard to beat as a guide to what the future may hold.
Short bursts of high inflation have a much lower impact on purchasing power than sustained periods of high inflation. But last year’s Covid-19 shock to the labor market and supply chains means that it’s hard to know whether the economy is experiencing the former or entering a phase of more prolonged price pressures. Market measures of investors’ inflation expectations point to a moderate pickup in consumer prices in the coming years but are aligned with Powell’s view that a recent spike higher will prove transitory. For example, data from the Federal Reserve Bank of St. Louis show that five-year breakeven inflation, which reflects inflation expectations over the next five years, is 2.6% annually, or near its 30-year average.
The collective best guess of investors as aggregated by market prices is hard to beat as a guide to what the future may hold. Investors may therefore be best off tuning out the pundits and figuring out how to either outpace or hedge against the inflation that’s already anticipated in market prices.
Over the past three decades, U.S. stocks, non-U.S. developed market equities, and emerging market stocks have all had positive real returns. Adjusted for inflation, a dollar invested in the S&P 500 Index in 1991 would have grown to over $12 by 2021. This represents a 12-fold increase in purchasing power. Similarly, returns of currency-hedged global government and corporate bonds have outpaced U.S. inflation over this period.
An alternative is to buy short-duration corporate bonds while using derivatives called inflation swaps to protect against price rises.
Granted, average real returns of global stocks and bonds were positive regardless of whether inflation was higher or lower than average, with no reliable difference between the performance of each asset class. But just because this was the outcome on average does not mean that this was the case every year. Investors who are particularly sensitive to inflation may therefore want to hedge against the erosive impact of rising consumer prices.
One option would be to buy Treasury Inflation-Protected Securities, whose returns are linked to changes in the consumer price index. If inflation spikes up more than expected, owners of TIPS are compensated through an adjustment for the increase in CPI. This helps protect investors from an erosion in purchasing power.
An alternative is to buy short-duration corporate bonds while using derivatives called inflation swaps to protect against price rises. Such swaps involve paying a counterparty a sum that’s linked to current expectations for inflation in return for receiving an amount of money that depends on what inflation actually is at a given maturity. While this strategy involves more credit risk, it offers higher expected returns than TIPS-only strategies and permits greater diversification.
Outpacing and hedging against inflation are often important objectives for investors. The proportion of assets allocated to each goal can be linked to the investment horizon. For example, a large allocation to assets that are expected to outpace inflation may be appropriate for investors who expect to save and who don’t expect to spend their investment assets for many years to come. Assets that outpace consumer price rises seek to increase the purchasing power of savings, enabling more consumption in the future. On the other hand, investors who are moving closer to the date at which they will stop saving and start spending their savings may want more certainty around how much their wealth will be worth after adjusting for price rises. In this case, a larger allocation to inflation-hedging assets can help provide higher certainty.
Investors don’t need to outguess markets or undermine their portfolio objectives to outpace or hedge against inflation. They should, however, avoid overreacting to short-term fluctuations in consumer prices.
Originally published by Reuters Breakingviews.
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