Some results may be more surprising than others.
1. Fixed income. Traditional government and corporate bonds haven’t tended to fare well during short-term inflationary spikes, assuming interest rates rise as well. For bonds generally, increases in yields erode current bond prices, due to the effects of inflation and market segmentation (investors prefer newly issued bonds at higher yields, while existing bonds have to reprice lower to provide the same yield to maturity). Bonds tend to especially shine in deflationary or low-growth episodes, when interest rates are also falling—making higher coupons increasingly more attractive. It’s a nuanced story, though, and based on how fast rates rise. As might be expected, less damage happens during periods when rates rise gradually compared to when the rise is rapid. On the positive side, a higher interest rate raises the longer-term total return expectation for bonds since multi-year return is closely tied to starting yield.
2. TIPs. By design, the returns of Treasury Inflation-Protected Securities are tied to CPI inflation readings. However, the market for TIPs remains small relative to that of standard nominal treasuries, and they’ve gone through stretches of appearing perpetually expensive, likely due to high demand for the concept but limited supply. Unbeknownst to some buyers, many TIPs are longer-duration bonds, a trait that can also enhance volatility when real yields change, as is the case with long-term traditional bonds with changes in nominal yields. There is a positive correlation with inflation no doubt, but other asset classes may offer more bang for the buck. One negative is that TIPs can have a higher correlation to equities and risk assets than do other bonds, so they tend to provide less portfolio diversification than do conventional treasuries and corporates.
• From a shorter-term standpoint, it’s all about the breakeven rate, which is the anticipated inflation built into TIPs yields (currently about 2.7% on the 10-year and 3.1% on the 5-year). If realized inflation over that maturity period is higher than breakeven, an investor is better off in TIPs. Otherwise, TIPs are likely to underperform nominal treasury bonds of the same maturity. Ideally, a time to invest in TIPs is when inflation expected by the market is low, but then starts rising at a faster rate than anyone expects—however, these bonds have tended to reprice quickly, making that window of opportunity fairly small.
3. Floating rate bank loans. These act in an almost opposite fashion from traditional bonds in that the yield is not based on a fixed rate, but a variable one tied to short-term market rates (and a credit spread). As these rates rise, as they can in response to central bank policy, the yield-based return for bank loans also rises. While many companies that issue such loans tend to be mid- to lower-rated, loans are collateralized and lie higher in the capital stack than traditional bond debentures. The correlation of bank loan returns with inflation has been stronger than that of fixed-rate bonds, due to the different responses to interest rate changes. These have been effective hedges against traditional bonds in the past, although they do contain credit sensitivity.
4. Equities. Results are mixed, depending on the sector and level of inflation. Low to moderate inflation can be a positive influence on company revenues, assuming that this coincides with underlying economic demand, and underlying costs can be passed on to consumers. However, if inflation rises to higher levels (such as 6%+, for example), companies are less able to profitably pass on cost increases without sacrificing sales volume. In that event, high inflation can become problematic for equities. Additionally, higher interest rates that can accompany inflation can raise borrowing costs and can decrease modeled company valuations due to the present value of money effect. Over time, of course, the embedded risk premium has resulted in higher returns for equities, which have outperformed inflation over longer time periods.
5. Real estate. Real assets have been sought out due to their nature of having traditionally at least tracked inflation, making these a bit of a classic hedge. For commercial properties, leases can contain CPI escalators, which insulate real rental income from inflation’s impacts. Rising interest rates can be a problem for real estate, however, due to higher financing costs and a carryover effect on capitalization rates used in valuations.
6. Commodities. These have been one of the best performers in an inflationary regime, particularly in one where ‘stagflation’ has occurred. In fact, the broad S&P GSCI Commodities Index has a high rolling 3-year ‘beta’ vs. CPI over the past 50 years, although correlation isn’t perfect. The reason for this is that commodities are both a cause and effect of inflation forces—a chicken-and-egg problem. The CPI inflation basket includes several commodities, including petroleum and food, as well as derivatives of those products (plastic, trucking rates, restaurant meals, etc.) so as commodity prices rise, so do costs and consumer inflation. Such expectations or underlying supply/demand conditions can exacerbate commodity hoarding or speculation, driving these prices higher and perpetuating the cycle. We have certainly seen this during the pandemic recovery, breaking commodities out of their long slump associated with two decades of contained inflation and few surprises.
7. Precious metals. Often thought of as a classic inflation hedge, the historical results are actually mixed. In some inflationary environments, gold and silver have provided protection, but in others, they haven’t. In fact, their correlation to equities and fixed income is literally close to zero over the long-term, which is a byproduct of their randomness of returns. Technically, they could still be considered useful from a portfolio construction standpoint, but less so than commodities broadly (mostly due to the energy sector). This group—gold in particular—has fared well in investor ‘risk off’ environments, much like long-term treasury bonds. Inflation and ‘risk off’ haven’t tended to be correlated, though, as financial distress tends to be deflationary force on the economy. The strength and weakness of the U.S. dollar also plays a key role in the performance of this segment.
8. Cash (U.S. dollar). This is another mixed bag, interestingly, based on the definition used. Currencies for nations experiencing high relative inflation have tended to depreciate, so cash under a mattress can buy less and less. However, short-term money market assets may benefit as interest rates rise, providing more income and serve as a shelter from volatility in other assets. At the same time, inflation can cause costs to rise at a faster rate than cash can be preserved and grown, so it has still been an eroding asset long-term.
9. Cash (non-dollar). Assuming inflation isn’t a global phenomenon, currencies of countries with more stable/lower inflation should maintain their value better than currencies of less stable/higher inflation countries. (This has been a big reason why certain developed market currencies, such as the Japanese yen and Swiss franc, have been sought out for stability compared to, say, those of emerging markets.) At the same time, higher relative real yields in a country can be attractive to investors, and help bolster demand for a currency. If inflation is global, though, this basic relationship can be cloudy (which could be the case today).