Think back to 1980. It was the year Ronald Reagan was elected president. It was also the year the average annual U.S. inflation rate reached a whopping 13.5%.1
What a difference three decades make. During the 30 years from 1981 through 2010, U.S. inflation averaged just 3.1% annually. And in the following half decade it was even lower—averaging a mere 1.7% annually from 2011 through 2016.2 (See “Taming inflation,” below.) But with commodity prices on the rise, health care costs increasing and bond prices in developed countries inching lower, inflation is again on investors’ minds.
From 1980 through 2016, the average annual U.S. inflation rate dropped 12.2%.
Source: U.S. Bureau of Labor Statistics, 01/1980–12/2016.
In fact, a little inflation is a good thing—a welcome sign of economic vitality following a decade of slow growth. However, even modest levels of inflation can undercut returns and erode purchasing power, particularly for those on a fixed income.
“No one expects inflation levels to reach those of the early 1980s,” says Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research, who anticipates inflation rates of perhaps 2% to 3% for the foreseeable future. “Still, it’s important to understand how even modest inflation can affect your investments.”
Here’s a look at how five major asset classes are expected to fare in the face of inflation, and tactics investors can employ to help weather its effects.
Bonds: A rise in inflation typically causes the price of bonds and bond funds to drop. Short-term bond funds usually fare better. However, even intermediate- and long-term bond funds generally recover by gradually reinvesting in higher-yielding bonds as rates rise.
Looking beyond maturity, there are two varieties of bonds specifically designed to counter inflation:
- Floating-rate notes (a.k.a. floaters): Unlike traditional bonds, floaters have variable coupons that are based on a benchmark rate—plus a fixed spread—so a floater’s coupon payments rise along with its benchmark. For example, if a floater were to pay a spread of 50 basis points over a three-month London Interbank Offered Rate of 1%, its coupon would be 1.5%. Of course, a floater’s spread tends to reflect its risk level, so a floater with a higher spread may have a a greater risk of default and therefore a lower credit rating.
- Treasury Inflation-Protected Securities (TIPS): The principal value of these low-risk, government-issued bonds increases along with inflation, as measured by the Consumer Price Index. Once they mature, the bonds pay either the original or an adjusted principal—whichever is greater. That said, this inflation protection comes at a price: TIPS tend to offer lower yields than other government bonds, so if inflation doesn’t rise you may miss out on better returns elsewhere.
Cash: While cold hard cash may lose purchasing power in the face of inflation (see “Diminishing dollars,” below), cash equivalents like certificates of deposit, money market funds and short-term Treasuries tend to move in tandem with inflation. That said, cash equivalents don’t always keep pace with inflation and historically have underperformed equities over the long term.
Commodities: So-called real assets such as livestock and precious metals can be an effective short-term hedge against inflation. That’s because as goods become more expensive, so do many of the raw materials used to produce them. Of course, it’s impractical for regular investors to store pigs or platinum, so Schwab Asset Allocation Strategist Tony Davidow instead recommends mutual funds or exchange-traded funds that track a commodity index. However, Tony reminds investors that commodities should typically make up no more than 5% of a well-diversified portfolio.
Real estate: The value of commercial and residential property tends to rise with inflation, making real estate investments a potentially effective long-term hedge. Specifically, investors may wish to consider real estate investment trusts (REITs), which typically derive rental income from apartments, malls and storage facilities; as reak-estate prices increase, rents may climb with them, boosting investor returns. REITs are generally a far less effective hedge in the near term, however. That’s because rising rates can lead to a cut in the dividends they pay and send prices lower.
Stocks: Over the long term, equities have outpaced all but the worst bouts of inflation. From 1980 through 2016, for example, the average annual return of the S&P 500Ò Index was 11.5%, compared with an average annual rate of inflation of just 3.3% during the same period.3
Of course, not all stocks are equally good at taming inflation, but two types in particular worth considering are:
- Banks and other lending institutions: Financial firms generate a significant portion of their revenue from the spread between the interest paid on deposits and the fees and interest earned from loans. As inflation rises, banks tend to charge higher nominal rates on their products, thus widening their spreads and producing higher profits. By the same token, a slowdown in inflation and/or economic growth can have a disproportionately negative effect on such stocks.
- Energy stocks: Inflation and rising energy costs often go hand in hand, leading to higher profits (and stock prices) for energy producers—provided global demand keeps up with production.
Over 30 years, the purchasing power of $100,000 in cash is undercut by even modest annual levels of inflation.
Source: Schwab Center for Financial Research. This example is hypothetical and provided for illustrative purposes only.
Recalibrating your portfolio
“Investors should always be aware of inflation and its impact, but I wouldn’t do anything drastic since we’re not expecting runaway inflation,” Kathy says. Instead, she advocates deploying extra cash toward investments that can help combat the effects of a slight uptick in prices, such as the bond, commodity, real estate and stock recommendations above. “Just a little bit of hedging should go a long way,” she says.
1U.S. Bureau of Labor Statistics.
3Morningstar and U.S. Bureau of Labor Statistics
What you can do
- Make sure your portfolio is diversified and aligned with your risk tolerance and investment timeframe. Want to talk about your portfolio? Call Schwab at 888-484-5340.
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