Inflation has been by far the most important economic variable affecting markets over the past two years. Investors are now grappling with how to incorporate this new reality into their personal financial and investment strategies after decades of disinflation, which at times has bordered on actual deflation.  

In addressing this issue, it is helpful to 1) assess the probability that this environment will be persistent; 2) examine the current performance behavior of various asset classes during this inflationary environment; and 3) consider whether long-term portfolio strategy allocations are warranted. 

Price pressure persistency

After three decades during which inflation declined from approximately 5% to roughly 2%, a multitude of interrelated elements surrounding the Covid pandemic conspired to swiftly rocket inflation higher, to over 6% on an annualized basis. This sudden and significant elevation in inflation has had profound impacts on consumers, corporations, the economy, and the financial markets.

Currently, as illustrated below, the core Personal Consumption Expenditure Index (PCE), which tracks prices consumers are paying for goods and services excluding volatile elements such as energy and food, is now showing signs of reversing. In other words, inflationary trends appear to be receding.

While core PCE is the favored index that the Federal Reserve (Fed) uses to monitor inflation, there are several other indexes that also track inflation, including the Consumer Price Index (CPI). Although nearly all are moving down, we believe that it is unlikely that inflation will swiftly drop back to the 2% range that the Fed has targeted as its primary policy objective of price stability.

Although commodity prices, including energy, have come down recently, price pressures persist in wages and in the important service sector of the economy. An inflation indicator the Fed has recently focused more attention on, known as the “super core index,” remains elevated. The super core index, which measures the inflation rate of a basket of goods and services, but excludes housing, food, and energy costs, is running about 5.6% on an annualized basis,ⁱ a full 1.2% higher than the core PCE.

The bond market has responded favorably to nascent signs of declining inflation. Bond yields, which spiked in 2022, have moved erratically but decidedly lower over the past six months. This move lower was also aided by a flight to quality that was triggered by the serious problems that arose in the banking industry. 

It is still too early to have clarity on the direction of inflation. Historically, inflation, once ignited, can become quite sticky and difficult to reign in. It appears likely that although inflation is coming down, it will not soon go back to the calmer days of 2%. There also are developing secular variables, such as deglobalization, politics, and demographics which are potentially longer-term issues affecting price and wage pressures. Inflation levels of 3-4% over the near term seem more likely, barring a serious economic downturn. In short, modest inflationary pressure seems more likely to persist. 

Asset class returns during the recent inflationary surge

It has been decades since investors have been rewarded consistently for investments that ostensibly benefit from an inflationary environment. The recent surge in inflation commenced suddenly near the beginning of 2021, accelerated to a peak in the first quarter of 2022, and then began a gradual descent this year. It is instructive to examine how various asset classes performed during the spike in inflation that began at the end of 2020 until today, and also during the shorter time period from the inflation peak in 2022 to today. It also is important to take into consideration the historic volatility (a proxy for risk) that each of these asset classes exhibit.

Below is total return performance information for various asset classes for the time frames mentioned previously. Publicly traded exchange traded funds (ETFs) that track specific asset class indices, and the Thrivent Money Market Fund, are used as proxies for the various asset class returns. Historical volatility statistics using standard deviation of returns are also included to provide a general sense of the degree of risk.

Note that the asset classes have been rather subjectively grouped as either “consensus”, “potential” or “conventional” asset classes. The reasoning is that “consensus inflation assets,” including gold, commodities, and treasury protected securities (TIPs), are commonly thought of as having attributes that provide protection in an inflationary environment. The category of “other potential inflation assets” include the traditional asset class of real estate (REITs) and the new and sometimes controversial asset class of Bitcoin crypto currency. Finally, “conventional assets” include cash (money market funds), the broad bond market (Bloomberg Aggregate Bond Index), and the S&P 500^®. These are the standard assets that would make up the bulk of a traditional investor’s portfolio.

Although this recent inflationary period has been very short, some observations can be made that may provide investors some perspective on how various assets may perform if elevated inflation rates persist.

“Consensus” inflation assets

The consensus inflation assets (gold, commodities, and TIPs) provided anything but consistent protection from inflation. Not surprisingly, commodities did perform exceptionally well. However, the surge in commodity prices was aided by the very unusual combination of factors affecting the global economy, such as the pandemic, the war in Ukraine, and China’s suspension of its lockdown policies. Furthermore, as fears of a recession have grown, commodity prices overall have come down since peaking last year. That being said, almost by definition, commodities typically perform well during periods of persistent inflation.

Gold, as a subset of commodities, surged initially as inflation rates rose, but experienced significant volatility through most of 2021 and 2022. It hit a three-year low in October 2022 before surging about 20% through the end of April 2023. But, in all, gold has provided only modestly higher returns than cash invested in a money market fund since the beginning of 2021. Gold does have a history of providing very long-term value preservation, but as an asset without income, it is challenged in providing real inflation-adjusted growth. 

TIPS were not a great hedge during this burst of inflation either. Although TIPs performed meaningfully better than the broad bond market, they still had negative returns in an environment that saw both nominal and real fixed income yields surge in response to the unexpected jump in inflation. However, now that yield levels have been reset after the Fed’s aggressive tightening campaign, 10-year TIPs have been trading recently at a real yield of about 1.3%.

Other potential inflation assets

Real estate has been considered a potential beneficiary of inflation. However, a distinction must be made between residential and commercial real estate. Residential real estate prices surged initially as inflation rates rose, but home prices peaked in June 2022 and have fallen about 5%ⁱⁱ since then in response to rising mortgage rates. Rental rates have also leveled off after a sharp spike in 2021 and 2022. Commercial real estate and REITS also performed well initially in response to concerns over inflation. However, the twin issues of rising interest rates and the secular shift to remote work policies reversed this trend, leading to significant underperformance over the past year. Going forward, these twin issues will continue to create headwinds for commercial real estate and REITS.

As for crypto currency, and Bitcoin specifically, it failed as a hedge against inflation, experiencing heightened volatility over the past two years.

Conventional assets

Cash, invested in a traditional money market fund, which has historically been less risky than equity and bond investments, provided a rather modest return, while exhibiting no volatility. Although very simple and unglamorous, money market funds, with current yields of roughly 4.5%, will continue to be attractive, especially for the very low risk component of an investor’s portfolio. If inflation unexpectedly moves higher again, forcing the Fed to raise short term rates further, money market yields may also increase. 

Not surprisingly, long-term bonds suffered significantly as inflation and interest rates both surged higher.  However, it is likely that the Fed will soon pause in its aggressive policy stance, which may provide some stability to the bond market and potentially improving performance prospects. If inflation continues to move lower, we believe that bonds would provide annualized returns in the range of their current yields of 3.5-5.0%, depending on maturity and credit quality. 

The stock market performed surprisingly well during the first year of rising inflation, but ultimately succumbed to the realities of persistent inflation, higher interest rates, and growing fears of recession. Although stocks have rebounded somewhat in 2023, corporate management teams are clearly pivoting to strategies that address these inflationary pressures. The ability to stem rising costs through productively enhancements or right sizing operations will be critical to supporting profitability. Persistent inflation could contribute to continued stock market volatility in the short term. Longer term, corporate managers have multiple levers that can be used in response to inflation. 

Portfolio considerations

Although the recent burst of inflation has been relatively short in duration, it does provide some insight into how various assets might behave if inflation remains persistent. The recent performance of several assets that historically have been considered inflation hedges provided little if any incremental benefit over a conventional portfolio of stocks, bonds, and cash. The exception is commodity assets. However, it is difficult for many investors to easily access the commodity markets directly. Most securities that provide a vehicle for obtaining exposure to commodities are dependent on the commodity futures market, which has its own idiosyncratic complexities and risk. 

Our current view is that inflation will continue to abate, but that it will not reach the Fed’s goal of 2% over the next year. Thus, inflation will continue to have a significant influence in the capital markets, but not to a degree that requires wholesale asset allocation changes or special allocations to assets that historically have been considered inflation hedges. The recent performance of these perceived inflation hedge assets largely supports this approach.