January 31st, 2018 | by

Where to Invest if Inflation Picks Up

  • Inflation has been subdued globally since 2009, but some key measures of inflation have shown life recently.
  • Looking back in history, commodities, gold, REITs, and emerging-market equities proved to be outperformers when inflation rates were high and during periods of unexpected jumps in inflation.
  • While predicting inflation movements is hard, a well-diversified portfolio with an allocation to hard assets seems prudent.

“Inflation is as violent as a mugger, as frightening as an armed robber, and as deadly as a hit man.”

That quote, from former President Ronald Reagan*, seems almost quaint today at a time when the Federal Reserve (among other central banks) struggles to push the inflation rate up to 2%. Since 2009, inflation has been subdued globally, making it difficult to conceive of a return of the dreaded monetary hit man. Yet in recent months, some prices and key measures of inflation expectations have sprung to life again.

From June 2017, to January 25, 2018, oil prices surged 54% and broad-based commodities (S&P GSCI index) gained 31%.The 10-year inflation breakeven rate, a measure of inflation expectations that reflects the yield differential between 10-year Treasuries and comparable Treasury Inflation-Protected Securities (aka TIPS), widened from 1.7% in June 2017 to 2.1% on January 25. The labor market, with unemployment at 4.1%, is tight; economic growth, fairly robust in recent quarters, should be further stimulated by the large-scale tax cuts that kick in this year; and the weak US dollar should translate into higher prices of imports.

With that backdrop, I thought it would be timely to look back in history to assess how asset classes have performed under different inflation scenarios. We reviewed more than 30 years of data and studied two separate inflation environments: “positive unexpected inflation,” which we define as periods with 12-month actual changes in the CPI that were a least 0.5 percentage points higher than forecasted; and asset returns during low-, medium-, and high-inflation regimes.

*Reagan made this statement in 1978, when the consumer-price inflation rate was 9% and Reagan was preparing to run for President in 1980 against incumbent Jimmy Carter. In both 1979 and 1980, CPI was 12% to 13%.

CPI and Asset Class Returns

Exhibit 1 presents the one-year returns of more than a dozen asset classes during periods of unexpectedly high CPI rates. Perhaps it is little surprise that the winner is commodities, which on average jumped nearly 28% in times of unanticipated spurts in inflation. Other hard assets (gold and REITs) also proved to be worthy hedges against inflation shocks. Interestingly, equities from developing countries, many of which are heavily exposed to natural-resource industries, outperformed gold and REITs and returned more than twice as much as US and other developed-country equity markets.


For the second study, we defined inflation scenarios like this: Low, year-over-year CPI less than 2.1%; Moderate, 2.1% to 3.2% CPI; and High, inflation of greater than 3.2%. As shown in Exhibit 2, commodities again took the crown in high-inflation periods (+23.6%), while suffering severe losses in low-inflation environments. TIPS and US REITs both registered double-digit returns in high inflation, but second place was again taken by emerging-market equities (+18.5%), which also badly trailed behind US and developed-international stocks in low-inflation periods. (For more detail, I invite you to read our recent papers, Asset Classes and Inflation: A Complicated History, and  Commodities and a Diversified Portfolio.)



Predicting future inflation rates is extremely difficult, and I make no forecasts here. But since inflation—and particularly unexpected bursts of inflation—can play havoc with the performance of some asset classes, we think there’s a strong case for a well-diversified portfolio to include an allocation to hard-asset inflation hedges such as commodities, gold, and real estate, along with a helping of emerging market equities.

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