In a high inflation environment, stocks and bonds will likely underperform other asset classes such as TIPS, commodities, and non-dollar assets. Table 1 shows the four major economic regimes and the asset class that performs best in each of them.
401(k) [RSP] investors have not yet truly experienced an inflationary regime. The 80s, 90s, and naughts were generally low interest rate and low inflation
environments, aiding stocks and bonds. Muted inflationary periods are wonderful for stocks and bonds. Stocks do well during disinflationary growth as low inflation reduces the discount rate that the markets will apply to future cash flows in determining the fair value of stocks. Low inflation also tends to be conducive to stable growth and is good for corporate profitability. Bonds are brilliant in disinflationary economic contractions as fears of the corrosive impact of inflation on bond prices wane.
So which asset classes perform best in high inflationary periods? Commodities when the economy is growing and TIPS when the economy is faltering. Commodity prices are pushed up by strong global demand; continued growth in emerging
markets will likely fuel shortages of commodities. Like nominal bonds, TIPS prefer slower economic environments because they benefit from falling
interest rates and lose value when rates increase.
We advocate the use of three pillars for our retirement portfolios: stocks, bonds, and inflation hedges. For investors who are confident that inflation will not be a serious issue in the coming 20 or 30 years, this can be a small pillar serving as an insurance policy in case theyâre wrong. For investors who fear that our soaring debts will trigger inflationary shocks in the years ahead, this can be a large pillar serving to protect their purchasing power as inflation crushes
the purchasing power of their mainstream holdings.
As we have expressed in past issues of Fundamentals, we believe that the long-term challenges from the â3-D Hurricaneââ deficit, debt, and demographicsâwill lead to serious bouts of inflation in the years ahead.6 Investors should be positioning for a different economic regime now.
Inflation Hedging: Stand-Alone Fund Options
One way for 401(k) [RSP] investors to hedge inflation risks is to invest in real return assets, such as TIPS, REITs, emerging markets stocks or bonds, and/or commodity funds. Despite the attractive inflation hedge characteristics of these alternatives, all are suboptimal stand-alone fund options. Why?
TIPS pay puny yields. As of late September 2010, the 30-year and 10-year TIPS ârealâ yields are floating around 1.5% and 1%, respectively, with some of the shorter maturity TIPS offering a negative yield!7 This would seem too low given that the average real yield on 10-year TIPS since 1997 has been 2.7%. But the average real yield on 10-year Treasury bonds since 1926 has been only 1.9% net of inflation. Shouldnât we expect to earn less in an aging, mature economy
with slower growth than weâve seen in the past (what PIMCO calls the âNew Normalâ)? TIPS are better viewed as insurance against reflation, not as a source of lofty real yields. REITs and commodity funds tend to be volatile and, therefore, the likelihood of 401(k) [RSP] participants chasing performance by investing in these funds after a short period of strong returns is high. Investors consistently pick the top performing funds expecting past performance to continue.8 As an example, Morningstar found the biggest S&P 500
Index mutual fund turned in an official 10.2% return over a recent 10-year period through 2005, while the average investor in the fund returned just 6.5%, losing almost 4% by chasing returnsâin an index fund!
If individual investors chase returns in an index fund, imagine the temptation in narrowly focused asset classes like REITs and commodities! These have wide swings in returns, encouraging investors to pile into these assets after impressive
runs and to then throw in the towel at the bottom. During the past decade, poor timing by fund investors led to an average 2.7% shortfall in TIPS,
high-yield bonds, emerging market bonds, REITs, commodities, and sector fund categories compared to official fund returns. The average shortfall of more broadly diversified funds? Just 0.5%!9
Inflation Hedging: Integrated Fund Options
We believe plan sponsors should offer integrated real return fund alternatives in their 401(k) [RSP] plan roster, avoiding the pitfalls of investing in individual asset classes and performance-chasing tendencies. Ideally, these integrated real return solution funds would be able to perform well in a variety of economic and inflationary regimes.
