Most people understand that inflation increases the price of their groceries or decreases the value of the dollar in their wallet. In reality, though, inflation affects all areas of the economy — and over time, it can take a bite out of your investment returns.
What is inflation?
Inflation is a rise in the average cost of goods and services over time. It’s measured by the Bureau of Labor Statistics, which compiles data to determine the Consumer Price Index (CPI). The CPI tracks the cost of goods such as gasoline, food, clothing and automobiles over time to gauge the overall rise in the price of consumer goods and services.
In January 2020, the CPI was 2.3.1 That means overall prices increased by 2.3 percent over the last 12 months. In theory, this means a car that cost $20,000 in 2019 would cost $20,460 in 2020.
Supply and demand play an important role in inflation. Prices tend to rise when demand for a good or service rises or supply for that same good or service falls. Many factors affect supply and demand nationally and internationally, including costs of goods and labor, taxes on income and goods, and availability of loans.
“As an example, during the COVID-19 pandemic, we had a sudden shock of people forced to stay home,” says Rob Haworth, investment strategy director at U.S. Bank. “This led to an excess of many goods that people could no longer buy during the shutdown, such as automobiles. This has impacted the relative price of cars.”
Indicators of rising inflation
There are three drivers that can contribute to a rise in inflation, often referred to as “reflation.”
- Federal Reserve (Fed) monetary policies, including interest rates. Currently, the Fed has committed to keeping interest rates low. This can incentivize low-cost borrowing, which can spur economic activity and increase demand for goods and services.
- Energy prices, specifically oil. Since oil is vital for producing and transporting goods, its demand is closely related to economic activity. Oil prices have fallen significantly in recent months, reflecting the sharp decline in consumer and business demand. As economic activity gradually returns to normal levels, demand for oil and gasoline should rise and push energy prices higher.
- Regionalization, or reducing dependence on imported goods and services. Over the past decade, the transfer of production overseas has been about seeking the lowest cost producer. The return of factories to the U.S. means the cost of production, including goods and labor, is likely to rise, creating inflation.
“An economic rebound and modest recovery in inflation will influence future returns across asset classes. Investors should consider the potential impact on their investment strategies,” says Haworth.
Read more from our investment leaders on how inflation could impact investors in 2021.
How can inflation affect investments?
Assets with fixed, long-term cash flows tend to perform poorly when inflation is rising, since the purchasing power of those future cash flows falls over time. Conversely, commodities and assets with adjustable cash flows (e.g., property rental income) tend to perform better with rising inflation.
Inflation can shrink your savings even if you’ve secured your funds in a savings account with an average interest rate.
In theory, when you’re working, your earnings should keep pace with inflation. When you’re living off your savings, as in retirement, inflation diminishes your buying power. It’s important to factor inflation into your retirement savings to ensure you have enough assets to last through your retirement years.
Fixed income investments
Typically, investors buy fixed income securities such as bonds, treasuries and CDs because they want a stable income stream in the form of interest payments. However, since the rate of interest remains the same on most fixed income securities until maturity, the purchasing power of the interest payments declines as inflation rises. As a result, bond prices tend to fall when inflation is increasing.
One explanation is that most bonds make fixed interest, or coupon payments. Rising inflation erodes the purchasing power of a bond’s future (fixed) coupon income, reducing the present value of its future fixed cash flows. Accelerating inflation is even more detrimental to longer-term bonds, given the cumulative impact of lower purchasing power for cash flows received far in the future.
According to Haworth, “Riskier high yield bonds have some equity-like characteristics, and they tend to suffer less than their investment grade counterparts when inflation is rising, given their higher relative interest payouts.”
According to analysis performed by the U.S. Bank Asset Management Group, stocks have held up well against inflation over the last 30 years.2 In theory, a company’s revenues and earnings should increase at a similar pace as inflation. This means the price of your stock should rise along with the general prices of consumer and producer goods.
In the past 30 years, U.S. stocks have tended to rise in price somewhat when inflation is accelerating, though the relationship is not particularly strong.
Larger companies tend to have a stronger relationship with inflation than mid-sized companies, and mid-sized companies have had a stronger relationship than smaller companies. Foreign stocks in developed markets tended to fall in price when inflation was rising, and emerging market stocks displayed an even stronger negative relationship.
“Larger U.S. company stocks may provide some benefit in modestly rising inflation environments,” Haworth notes. “However, they are not the most effective investment tool in more robust inflation environments.”
Real assets, such as commodities and real estate, tend to have a positive relationship with inflation, according to analysis performed by the U.S. Bank Asset Management Group.
Commodities have historically been a reliable way to position for rising inflation. Inflation is measured by tracking the price of goods and services which often contain commodities directly, as well as products closely related to commodities. Energy-related commodities like oil have a particularly strong relationship with inflation (see above). Industrial and precious metals also tend to rise when inflation is accelerating.
“Commodities have important drawbacks, however,” says Haworth. “They tend to be more volatile than other asset classes, do not produce any income, and have historically underperformed stocks and bonds over longer time periods.”
When it comes to real estate, property owners can often increase rent payments when prices of goods and services are rising, which can flow through to profits and investor distributions.
How to defend your portfolio against inflation
Inflation can have a significant impact on your portfolio over time. Alongside working with a financial professional, consider two steps that may help protect your investments against inflation:
- Diversifying your portfolio with exposure to U.S. stocks and real assets such as commodities may help you shield your money against inflation. However, diversification and asset allocation do not protect against losses or guarantee returns.
- Consider Treasury inflation-protected securities (TIPS). The rate of return on TIPS, issued by the U.S. government, is adjusted in accordance with the CPI. This can result in a somewhat more reliable performance than other types of bonds and asset classes. However, TIPS returns and income tend to be relatively low.
Inflation might be beyond your control, but that doesn’t mean you can’t take actions to help preserve your investments and savings from its effects.
Learn how interest rates affect investments.
Past performance is no guarantee of future results. All performance data, while obtained from sources deemed to be reliable, are not guaranteed for accuracy. Indexes shown are unmanaged and are not available for direct investment. U.S. large-cap stocks: The S&P 500 Index is an unmanaged, capitalization-weighted index of 500 widely traded stocks that are considered to represent the performance of the stock market in general. Developed foreign stocks: The MSCI EAFE Index includes approximately 1,000 companies representing the stock markets of 21 countries in Europe, Australasia and the Far East (EAFE). Emerging market stocks: The MSCI Emerging Markets Index is designed to measure equity market performance in global emerging markets. Investment grade bonds: The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar- denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, mortgage-backed securities, asset-backed securities and commercial mortgage-backed securities. Treasury inflation-protected (TIPS): The Bloomberg Barclays U.S. TIPS Index includes all publicly issued, U.S. Treasury Inflation-Protected Securities that have at least one year remaining to maturity, are rated investment grade and have $250 million or more of outstanding face value. Real estate stocks: The Dow Jones U.S. Select REIT Index measures the performance of publicly traded Real Estate Investment Trusts (REITs) and REIT-like securities. Commodities: The S&P GSCI is a composite index of commodity sector returns, representing an unleveraged, long-only investment in commodity futures that is broadly diversified across the spectrum of commodities. The S&P GSCI Sub-Indices provide reliable and publicly traded benchmarks for investment performance in various commodity markets (Wheat, Energy, Precious Metals, etc.). The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them.
Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility. The value of large-capitalization stocks will rise and fall in response to the activities of the company that issued them, general market conditions and/ or economic conditions. Stocks of small-capitalization companies involve substantial risk. These stocks historically have experienced greater price volatility than stocks of larger companies and may be expected to do so in the future. Investing in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Investment in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities. Investments in high yield bonds offer the potential for high current income and attractive total return, but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a bond issuer’s ability to make principal and interest payments. The municipal bond market is volatile and can be significantly affected by adverse tax, legislative or political changes and the financial condition of the issues of municipal securities. Interest rate increases can cause the price of a bond to decrease. Income on municipal bonds is free from federal taxes, but may be subject to the federal alternative minimum tax (AMT), state and local taxes. There are special risks associated with investments in real assets such as commodities and real estate securities. For commodities, risks may include market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes and the impact of adverse political or financial factors. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates and risks related to renting properties (such as rental defaults). Treasury Inflation-Protected Securities (TIPS) offer a lower return compared to other similar investments and the principal value may increase or decrease with the rate of inflation. Gains in principal are taxable in that year, even though not paid out until maturity.
2 “Investing when inflation is on the rise,” U.S. Bank Asset Management Group, July 2020.