If inflation is high and sustained, then it will have a significant impact on your investment strategy. Higher inflation may make assets such as commodities an attractive investment option.Common wisdom is that bonds will fare poorly in an inflationary environment. Though, there’s some truth to that. In an inflationary environment, bonds could actually beat stocks, and we have seen this occur with some regularity historically.
Relative vs. Absolute Performance
The key thing to understand about bonds in an environment of rising inflation, is yes, returns can be poor, but often stocks do perform a lot worse. Perhaps it’s little comfort, but historically during inflationary periods, you would have lost less money in high-quality government bonds than with major stock indices.
Duration
The fundamental reason is duration. Investment have cash flows that far out into the future. Duration measures far into the future those cash flows are. If money in the future is worth less, because of rising prices, then the value of those investments falls. Those investments with cash flows spanning further out into the future can fall more.
Of course, this hurts bonds. Your 1.6% coupon on a 10-year Treasury bond is pretty unattractive if inflation is running at 4.2% a year as it is currently. Each year your bond is paying you less in real terms after inflation. However, stocks do have a similar issue, it just requires a little more analysis.
With an investment in a stock, the profits can stretch far into the future. For example, whereas a bond might pay you back in full within a decade, a dividend-paying stock might take 40 years or so to return your investment on some basic assumptions.
That’s not necessarily a bad thing, because stocks have other desirable characteristics such as the ability to grow sales and raise prices over time. Yet, during times of high inflation, duration matters. The further cashflows are out into the future, the more they may be impacted by the prospect of rising inflation. The cashflows associated with stocks are generally further out into the future than with bonds, hence stocks can see a greater inflationary decline.
The Historical Perspective
History bears this out. Often, in periods of high inflation stocks fare a little worse than bonds. On average a 10-year Treasury bond loses around 5% whereas stocks lose 7% during inflationary periods. This according to recent research on historical inflation and asset returns over past decades.
Volatility
Of course, those averages conceal volatility. The worst outcome for stocks is a 46% loss during the OPEC oil embargo of the 1970s, the worst outcome for bonds is a 38% loss during the Iranian revolution later in the same decade. Neither asset does well, but bonds can often do a little better.
So generally stocks can underperform bonds during inflationary spikes because of the longer term nature of a stock’s cashflows. Now, it’s never quite that simple. Stocks can often raise prices during inflation, whereas bond payments are generally fixed. Still the valuation impact on stocks typically outweighs their pricing power and other benefits.
Also the duration of your bond matters. A 30-year Treasury bond ends up tracking stock returns more closely due to its greater duration. Corporate bonds can fare worse than government bonds at times of inflationary stress. On the other hand, shorter term bonds and those with built-in inflationary protection, such as TIPS, can sometimes do quite a bit better than stocks should inflation rise.
Still, the idea that bonds are likely to get hit by inflation worse than stocks should high inflation last, may prove to be a myth. Especially at a time when bonds have had a very sluggish start to 2021 while stock valuations, especially in the U.S., appear elevated compared to history.
This article originally appeared on Forbes.
