Many investors are wondering which asset classes would be the best guardians of real value during inflationary times.  Some investors believe the best investment hedges against increasing inflation have been gold and commodities. Is this the case? Or are there other asset classes that historically have performed well during times of rising inflation?  Should investors change their asset allocation when they fear higher inflation?

Our conclusion will be that U.S. small cap value and micro cap stocks, which have favorable risk/return profiles relative to gold and commodities and are part of our recommended portfolio allocation, have done very well during inflationary times.

Inflation: Present, Past and Future

The current recession and sluggish consumer demand have recently led to deflation (negative inflation). For example, oil, which peaked at $147/barrel in July 2008, has since fallen to about $55. In the 12 months ending April 2009, the Consumer Price Index (CPI) actually fell 0.7 percent. The year on year declines in March and April are the first since 1955.

The following chart shows the 12-month rate of CPI inflation since 1970:

Figure 1

While current inflation is low or even negative, the future is far from certain. The Federal Reserve has injected more than $800 billion into the economy in the last eight months, and the federal budget deficit for fiscal year 2010 will be a whopping $1.2 trillion. Both could lead to higher future inflation.

The expectations for long term inflation are still relatively benign. The Livingston Survey, a well respected semiannual survey of economists’ expectations, last published by the Federal Reserve Bank of Philadelphia in December 2008, expects that CPI will average 2.5 percent over the next 10 years. Another measure of inflationary expectations is the difference in yield between Treasuries and Treasury Inflation-Protected Securities (TIPs) of the same maturity. As of April 30, the breakeven inflation rate between five-year Treasuries and TIPs was 0.86 percent, for 10-year bonds it was 1.49 percent and for 30-year bonds it was 1.78 percent. This suggests the markets expect inflation to increase over time, but to remain under control.

Asset classes

How does inflation affect different asset classes, such as bonds, real estate investment trusts (REITs), stocks, gold and commodities? We will discuss how inflation may theoretically affect different asset classes, and then look at how these asset classes have actually performed in the past.

Since our investment philosophy has consistently been to recommend a very well diversified equity portfolio comprised of low cost, tax efficient passive funds with a small cap and value tilt, we will look at these asset classes. To the extent data is available, we will also look at how gold and commodities have performed during the same time periods.

Theory and Expectations

Bonds

Inflation is bad news for most bonds, which pay periodic interest and repay principal at maturity. Inflation hurts long-term bonds more than short-term ones because it makes future repayments less valuable.

As inflation increases, interest rates usually increase. Investors in short term bonds can take advantage of higher interest rates by investing in new bonds as their current bonds mature.

It is possible to be inflation neutral with bonds by investing in TIPS, which are Treasury bonds whose principal and interest payments increase with inflation.

Investors with bond exposure in the Merriman portfolios invest in both short term bonds and TIPs (for tax-deferred accounts), gaining the benefit of both these inflation hedges.

(Please see the FundAdvice.com article “Treasury yields and fixed-income investing ” for a more detailed explanation of Merriman’s bond strategy and the steps we take to guard against the impacts of inflation in our bond portfolios.)

Real estate investment trusts

REITs may be hurt by inflation if the underlying real estate has long term fixed rate leases. REITs will benefit from inflation if landlords can raise rents when leases expire. These securities also will benefit from inflation as the underlying real estate increases in value.

The Merriman recommended tax-deferred portfolios have moderate exposure to both domestic and international REITs.

Stocks

The link between stock prices and inflation is complicated. To the extent they can, companies may try

to raise their prices during inflationary times to cover the higher cost of the labor and material necessary to produce their products. This may both contribute to higher inflation, and lead to higher profits which might raise stock prices. Raising prices, however, is more difficult to do in the globally competitive economy which exists today.

On the other hand, stock prices may suffer from unanticipated increases in the inflation rate. As we’ll see, some asset classes such as small cap value have performed better than the S&P 500 during inflationary times.

Gold and other commodities

Generally speaking, the price of gold and other commodities will increase with the inflation rate specific to that raw material sector. Commodity inflation could then flow through and impact the overall inflation rate. We live in an economy dominated by services, which make up 60 percent of the CPI, with goods making up the other 40 percent, so there is not a one-to-one relationship between commodity inflation and CPI. From 1970 – 2008, the Producer Price Index of All Commodities increased by 4.38 percent annualized, while the CPI index increased by 4.64 percent per year, showing the inflation in the service sector was higher than inflation in the commodity sector.

There are some other potential benefits to investing in commodities. People may flee to gold in times of political stress. A large imbalance in the supply or demand for a commodity, such as oil, may cause its price to increase much faster than the general rate of inflation, until equilibrium comes back into play. (For more on this topic, see an article by Dennis Tilley called “Why we still don’t favor commodities.”)

Reality and Performance

Long Term Performance of Gold

Figure 2 below shows the return (vertical axis) and risk (horizontal axis) of four asset classes (Treasury Bills, Treasury Bonds, gold bullion and the S&P 500) relative to CPI, from 1926 through March 2009.

Figure 2

As the chart shows, the S&P 500 handily outpaced gold, with nearly double the return. While gold did better than inflation, Treasury Bills also did so, with far less risk.

This next chart, Figure 3, compares the CPI and the annualized return for one-month Treasury bills, gold and the S&P 500 over the last 10 years, the last 20 years, and since 1926. The data in each case ends on March 31, 2009.

Figure 3

As you can see, gold had an excellent run over the last 10 years, showing a much higher annual return than either the CPI or the S&P 500 (which had a dismal negative return of -3 percent annualized). For the longer periods (20 years and from 1926) gold outpaced inflation, had only a slightly better return than the riskless one-month Treasury bill, but lagged behind the S&P 500.

Inflation Year Outliers

Both deflation and high inflation are bad for the economy. With deflation, if consumers and businesses thought prices would be lower in the future, they would defer current expenditures, hurting the economy today. High inflation is bad for lenders, people on fixed incomes and all those whose incomes may not keep pace with the rapid price increases.

Fortunately, there have not been many years in the United States when there has been deflation, or when inflation has been very high.

Since 1926 there have been 10 years with deflation, when prices actually went down, most of which occurred during the Depression. The most recent was 1954.

There have also not been many periods of persistent high inflation in the United States. Since 1926, there have been only 14 calendar years when inflation exceeded 6 percent. Four of these years occurred during and just after World War II. Two other years were 1969 and 1990. Between 1973 and 1981, the U.S. economy experienced eight years with inflation over 6 percent.

Figure 4 shows the returns of various asset classes from 1941 through 1947 when inflation exceeded 7.5 percent:

Figure 4

While the S&P returned 11.4 percent, an index of small cap value stocks returned an astonishing 28.2 percent.  The nine indicated years since 1970 when inflation exceeded 6 percent are shown in Figure 5.

Figure 5

Figure 6 shows the annualized CPI and returns of various asset classes (using Dimensional Fund Advisors (DFA)  funds or indices and the S&P 500) during the high inflation time of 1973 – 1981.

Figure 6

In this period, U.S. small cap value stocks again had the best return among these asset classes. International small cap, U.S. micro cap, REITs and U.S. large value all had returns which exceeded the CPI.

So, during the last two extended bouts of above-average inflation, U.S. small cap value had excellent returns. But this has not been the case every year.

Since 1990 is not included in the chart above, Figure 7 shows the return of various asset classes for that year, using DFA funds and the S&P 500. We also show the return of the Goldman Sachs Commodity Index, and the Fidelity Select Gold fund, which invests in gold mining stocks.

The two best performing asset classes in 1990 were commodities, at 28.1 percent and emerging markets at 22.7 percent. All other asset classes shown had negative returns, with the worst being U.S. small value.

Figure 7

Commodities vs. stocks

In the previous section we looked at the returns during high inflation years. Now let’s review returns for the 21-year period starting in 1988, the first calendar year for which we have data on the Goldman Sachs Commodity Index.

Figure 8

Each of the asset classes beat inflation for the overall period. The gold fund had a higher return than commodities, but both returned less than that of the S&P 500. The top five asset classes were emerging markets, U.S. small cap value, U.S. micro, REITs and U.S. large value.

The following chart shows the ending wealth in 2008, if $1 had been invested in each of these asset classes in 1988. Due to the power of compounding, $1 invested in emerging markets, U.S. small cap value or U.S. micro would have been worth much more than $1 invested in gold or commodities. The ending wealth with U.S. small cap value would have been worth 3.3 times the value of the gold investment and 3.6 times the value of the commodities investment.

Emerging markets can enjoy a double benefit from inflation. Many of those countries produce commodities, and could generate more revenues with inflation. These countries also have benefited and may continue to benefit from a faster growth than developed countries.

Figure 9

Finally, let’s see how return compared with risk for these various asset classes, as well as to the annualized increase in CPI. 

Figure 10

Ideally, we would like assets which have higher returns and lower risk (the northwest quadrant, moving up and to the left on the graph). Aside from emerging markets, every asset class which had higher returns than gold and commodities also had lower risk over this 21-year time period.

Conclusion

Over time, gold and other commodities have provided a return that has been better than inflation, but other asset classes, especially small cap value and micro cap, have performed even better.

Commodities are inputs into the production process. Companies, and their stock prices, benefit by improving the production process, inventing new products and finding new markets for their products. These activities tend to generate better returns than commodities by themselves over time.

Asset classes such as emerging markets, small cap value and micro cap have demonstrated substantially better returns, often with lower risk, over various periods of time which included both high inflation and more normal inflation.

We continue to believe that a portfolio which includes some reasonable amount of these asset classes could help moderate the impacts of inflation more effectively than investments in commodities.

We don’t know what the future will hold. There may be high inflation, deflation, average inflation, or some combination thereof. A portfolio of stocks and the appropriate bonds, with a healthy tilt toward small cap, value and international stocks, can provide inflation protection and also provide beneficial risk adjusted returns through a variety of inflationary environments. 

Larry Katz is Director of Research at Merriman.

Disclosure

Past returns are not indicative of future results. Results include reinvestment of interest, dividends, and capital gains. Results do not reflect any effect of taxes. This article provides investment-related information but not individual investment advice. Its content is not based on knowledge of any reader’s individual needs or circumstances. The investment securities and strategies discussed in this article are not suitable for all investors. Investors should not assume that any investment will be profitable.

(c) Merriman

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