Much has been written about inflation in recent months. While some argue inflation is here to stay, others have taken the position that we will resume the long-term trend of deflation due to technological innovation and overindebted economies once supply chain dislocations ease. Inflation tends to be an economic as well as psychological trend and once it takes hold can be difficult to slow or reverse. The Federal Reserve has recently all but acknowledged that inflation is not transitory. We consider it prudent to prepare for the worst yet hope for the best. It is uncertain what the future holds but it may be beneficial to review the asset classes that outperform in inflationary environments.
Historically, when inflation has averaged less than 2% annually stocks outperformed all other asset classes followed by high yield corporate bonds according to a 2021 Charles Schwab study (footnote herehttps://www.schwab.com/resource-center/insights/content/rising-inflation-what-it-means-tips-and-other-investments ). In the ten-plus years following the Global Financial Crisis, we have seen this low inflation environment and have witnessed stocks soar. While stocks and high yield bonds outperformed, commodities significantly lagged with double digit negative rates of return.
Source: Schwab Center for Financial Research with data from Bloomberg and Morningstar, using monthly data through March 2021. Each index has a different start date, so not all average total returns have the same amount of data points. Please see footnote 2 for start date for each index used. Indexes included are: S&P GSCI Index (Commodities), Gold United States Dollar Spot (Gold), ICE BofA U.S. Mortgage Backed Securities Index (MBS), S&P 500 Index (S&P 500), Ibbotson US 30-day Treasury Bill Index (1-month Treasury Bills), Bloomberg Barclays U.S. Corporate Bond Index (Investment Grade Corporates), MSCI EAFE Net Total Return USD Index (International Stocks), ICE BofA U.S. Municipal Securities Index (Municipal Bonds), Bloomberg Barclays U.S. Corporate High Yield Bond Index (High-Yield Corporates), Bloomberg Barclays U.S. TIPS Index (TIPS), Ibbotson US Intermediate-Term Government Bond Index (Intermediate-term Treasuries), and Ibbotson US Long-Term Government Bond Index (Long-term Treasuries). Total returns assume reinvestment of interest or dividends plus capital gains. Past performance is no guarantee of future results.
In October the CPI (Consumer Price Index) reading came in at 6.2%, the largest 12-month price increase since 1990. Previously, when inflation has averaged greater than 4% annually the asset classes that outperform shift noticeably. Commodities outperformed the broad asset classes by a large margin compounding at nearly 18% per annum and doubling the return of stocks. In high inflation regimes gold performs just behind commodities. Long-term treasuries, which typically perform in the middle of the pack during low inflation environments, become the least attractive assets to hold.
Source: Schwab Center for Financial Research with data from Bloomberg and Morningstar, using monthly data through March 2021. Each index has a different start date, so not all average total returns have the same amount of data points. Please see footnote 2 for start date for each index used. Indexes included are: S&P GSCI Index (Commodities), Gold United States Dollar Spot (Gold), ICE BofA U.S. Mortgage Backed Securities Index (MBS), S&P 500 Index (S&P 500), Ibbotson US 30-day Treasury Bill Index (1-month Treasury Bills), Bloomberg Barclays U.S. Corporate Bond Index (Investment Grade Corporates), MSCI EAFE Net Total Return USD Index (International Stocks), ICE BofA U.S. Municipal Securities Index (Municipal Bonds), Bloomberg Barclays U.S. Corporate High Yield Bond Index (High-Yield Corporates), Bloomberg Barclays U.S. TIPS Index (TIPS), Ibbotson US Intermediate-Term Government Bond Index (Intermediate-term Treasuries), and Ibbotson US Long-Term Government Bond Index (Long-term Treasuries). Total returns assume reinvestment of interest or dividends plus capital gains. Past performance is no guarantee of future results.
While commodities are the most attractive assets to hold in high inflation environments, they can be challenging to invest in as they exhibit high volatility, sharp drawdowns, and ETFs tend to be poor proxies of the underlying. Commodity futures contracts, with their embedded leverage, require large pools of capital to build diversified portfolios and keep risk measures within reason. Skilled commodity pool operators (CPOs) or commodity trading advisors (CTAs) can add value through their experience in systematically trading a broad universe of futures contracts across the globe. Broad diversification, the ability to participate both on the long and short side, processes to control volatility and reduce drawdowns can add significant value to an investor’s portfolio. As we have already seen in 2021, a regime change may be underway causing commodities to outperform other asset classes in the years ahead.