As the capital markets have improved, more investors have shifted their concern from weathering the financial crisis to anticipating the inflationary effects of rising federal spending and debt. This article explores two basic ways to address inflation and bond uncertainty, and highlights asset groups that may prove useful.

As you consider strategies, note the difference between expected and unexpected inflation. Asset prices already reflect the market's expectations about future inflation, given all available information. However, inflation may turn out to be worse than expected, which is what some investors may want or need to manage.

Hedging vs. Total Return Strategies

Investors can prepare for unexpected inflation by following one of two basic strategies -- hedging the immediate effects of inflation, or earning a total return that outpaces inflation over time.

Hedging involves choosing assets whose value tends to rise with inflation. Although holding these assets may reduce the total return of a portfolio, the positive correlation with inflation can help investors keep up with rising consumer prices, at least over the short term. Candidates for Hedging mainly include retirees, fixed income investors and others who would experience a diminished living standard during an inflationary period. These investors may be willing to forfeit long-term growth potential for more immediate inflation protection.

In a Total Return strategy, an investor attempts to outpace inflation by holding assets that are expected to earn higher real returns than the prevailing rate of inflation. This investor is willing to give up short-term inflation protection for an opportunity to grow real wealth. Younger or more opportunistic investors are typically well-suited here because they have many years until retirement and expect their earnings to advance faster than the inflation rate. As they save and invest for the future, they can accept more risk through greater exposure to higher-return assets.

To insulate a portfolio from unexpected inflation risk, both strategies may employ some combination of stocks, short-term fixed income (both U.S. and non-U.S.) and Treasury Inflation-Protected Securities (TIPS). 

Stocks

Equity securities have provided a positive inflation-adjusted return over the long term. From 1926 through 2008, the total US stock market, as measured by the CRSP 1-10 Index, outpaced inflation by an average of 6.16% per year. To achieve this higher expected real return in stocks, however, an investor had to accept more risk, as measured by greater volatility in returns, and endure periods when stocks did not outpace inflation. This is why stocks may be less effective for hedging short-term inflation and more suitable for investors who want to beat long-term inflation by earning a higher total return over time. 

Many people assume that high inflation leads to lower stock market performance, while low inflation fuels higher stock returns. In reality, inflation is just one of many factors driving stock performance. U.S. market history since 1926 shows that nominal annual stock returns are unrelated to inflation.

Fixed Income and Bond Diversification 

Higher inflation can hurt bond holders in three ways: through falling bond market values triggered by rising interest rates, through erosion in the real value of interest payments, and from lower real value in principal at maturity. This inflation exposure tends to impact the prices of long-term bonds more than those of short-term bonds, and investors can mitigate the effects of rising interest rates by holding shorter-term instruments.

When interest rates are climbing, a portfolio with shorter-term maturities enables an investor to more frequently roll over principal at a higher interest rate. This helps inflation-sensitive investors keep up with short-term inflation, and enables total return investors to reduce portfolio volatility.

Incorporating global bonds into an asset allocation may be useful for a variety of reasons. A non-U.S. bond allocation of approximately 10-20% of an investor's fixed income portfolio can be a good strategy for investors seeking to enhance returns and improve diversification, something this asset class has historically offered. (Global bonds have a very low correlation to stocks which, according to portfolio theory, reduces volatility.)   

International bonds can also be a good stabilizer during times of high stock market volatility, and it is a marketplace that is expanding rapidly.  It has been estimated that the global debt market has grown close to three fold over the past ten years, from $34 trillion in 2000 to $90 trillion at the end of last year.

Treasury Inflation-Protected Securities (TIPS)

Issued by the US government, TIPS are fixed income securities whose principal is adjusted to reflect changes in the Consumer Price Index (CPI). When the CPI rises, the principal increases, which results in higher interest payments. At maturity, an investor receives the greater of the inflation-adjusted or original principal. The inflation provision enables TIPS to preserve real purchasing power and hedge against unexpected inflation.

TIPS are generally a good short-term inflation hedge since principal is adjusted for changes in the CPI, although TIPS may also lose market value if real interest rates increase. They are also a good portfolio diversifier for some long-term investors due to their negative correlation with equities and relatively low correlation with most types of fixed income assets. (TIPS were introduced in 1997, so these correlations are based on a relatively short sample period.)

Commodities

Commodities, as well as gold and oil, are perceived as effective inflation hedges because their returns are positively correlated with inflation. But commodities are more volatile than stocks, and their returns do not always rise with inflation because of this. While adding diversification, including commodities within a portfolio may increase real return volatility, which could offset the benefits of hedging.

It is important to note that a broad-based stock portfolio may already have commodity exposure through ownership of companies involved in energy, mining, agriculture, natural resources, and refined products.

Summary

While the media have featured divergent opinions and theories about the effects of recent government actions on debt and inflation, no one really knows how consumer prices will respond to the complex forces at work in the economy and markets.

As you assess your exposure to a high-inflation scenario and form a strategy that reflects your financial goals and risk tolerance, consider the view that expected inflation is built into asset prices, which is to say that markets efficiently integrate all known information into prices. Thus, current prices already reflect expectations of future inflation. Only unexpected news will affect the inflation outlook.  Consider also that hedging unexpected inflation has a cost; investments traditionally regarded as effective short-term inflation hedges have lower historical returns than stocks, and some have much higher volatility. Evaluating assets solely on their ability to track inflation disregards the effect of volatility on returns and risk.

With the prospect for higher inflation upon us now for well over a year, investors may be best-served with the total return approach while also choosing assets based on their correlation with the CPI and their exposure to both domestic and non-U.S debt markets.  

By selecting assets with higher expected long-term returns, maintaining broad bond diversification and adding a hedging element, investors can seek to grow real wealth and preserve the purchasing power of their dollars while simultaneously guarding against the short-term affects of inflation.

Disclosures

Inflation is typically defined as the change in the non-seasonally adjusted, all-items Consumer Price Index (CPI) for all urban consumers. CPI data are available from the US Bureau of Labor Statistics.

CRSP is a non-profit center that also functions as a vendor of historical data. CRSP end-of-day historical data covers roughly 26,500 stocks, both active and inactive. OTC bulletin board stocks are not included.

Past performance is no guarantee of future results, and there is always the risk that an investor may lose money. Diversification neither assures a profit nor guarantees against loss in a declining market.

Information obtained from the Bank for International Settlements and from Dimensional Fund Advisors, a non-affiliated third party.