After recent concern about a seemingly endless slide of equity values regardless of size and value dimensions or global location and related concern about deflation and potential economic calamity, many investors and commentators are now worrying that policymakers’ response may cause significant inflation. In order to avoid the prospect of economic depression massive injections of liquidity into the financial system and even larger budget deficits by government could lead to significant levels of inflation. To be sure history teaches us that prolonged deflation is far worse than inflation. Deflation is associated with a decline in economic activity, severely negative growth rates and related significant declines in equity values.
Current inflation is low as are current expectations for future inflation. Policy makers have indicated their belief that future inflation is manageable. However, the concern is that these expectations can change as unforeseen economic realities change. With this concern many investors are wondering what portfolio asset allocations or hedges would in foresight be effective in maintaining and enhancing value.
Looking at the historical data on the following page with the assumption that to a meaningful degree “past is prologue” we conclude that our fundamental recommended portfolio which includes allocations of short-term high quality fixed income instruments and a diversified equity exposure that tilts to small and value is a prudent approach to inflation.
The chart above tracks the U.S. CPI from 1929-2008.
Since 1926 there have been 14 years with inflation greater than 6%. Twelve of these years are within the periods 1941-1947 and 1973-1981, during which inflation grew at an annualized rate of 7.5% and 9.2%, respectively.
The charts below show annualized returns for certain available asset classes and inflation rates for the high inflation periods 1941-1947 and 1973-1981.
In considering the data for these two extended periods of inflation we must be aware that these represent a small sample set and for 1990 (a year that saw a spike in inflation for one year then a return to much lower inflation) the results looked differently. When looking at the past to get an indication of the effect of inflation on asset classes for a prolonged period, the high inflation periods of 1941-1947 and 1973-1981 are all there is to look at.
When looking at the historical data on the next page the following items are noteworthy:
- Inflation outpaced most bonds and had more of a negative effect on longer term bonds. As inflation increases, interest rates typically increase. The rising of interest rates hurts long term bonds more because future payments of interest and principal are discounted at the current higher interest rate for a longer period of time than short term bonds. During periods of rising inflation investors in short term bonds can invest in higher bond yields as holdings of existing bonds mature. With regard to inflation the general lesson is to invest that portion of a portfolio’s fixed income component in short-term high quality bonds or bond fund.
- Periods of high inflation are generally not thought to be good for stocks. Companies try to raise prices but this can be a game of catch up and difficult to do in a globally competitive environment, especially if U.S. inflation is higher than in most other countries. During both high inflationary periods small cap, small cap value, and large cap value had substantially higher returns than inflation and the S&P 500. With regard to inflation the general lesson is to tilt the equity portion of a portfolio to small cap and value stocks.
- Gold and commodities generally rise with inflation, but how do they do over long periods of time? Inflation is difficult to predict and timing the holding of these assets is like stock picking, only for the very lucky. The last schedule on the next page shows returns for various asset classes and types from 1988-2008 (the longest period with data available for all these asset classes that include a commodities index). Note that returns for gold and the commodities index for this extended period were below that the S&P 500 and five year Treasuries and had significantly higher volatility. (continued on page 4)
Historically gold and commodities have provided a hedge against inflation but at cost of very high volatility. Inflation has historically had volatility much less than that of gold and commodities. It makes little sense to us to address inflation concerns with investments that have provided such a high level of risk with such a relatively low level of return. This is especially so when other asset classes are available that have historical returns greater than inflation during high inflationary periods and over long periods have provided much higher returns than gold and commodities and have generated about the same volatility. With this in mind it would be difficult to reduce equity exposure in a portfolio in order to include gold or commodities.
With regard to inflation we recommend avoiding gold and commodities and using those asset classes that historically have generated higher returns with similar volatility.
We believe that the historical evidence with regard to inflation supports our general investment philosophy and portfolio design.
Investing is a long term proposition. There will be periods, sometimes long periods, when general historical trends of risk and return do not appear. It is important to remain steadfast. We have seen in the last few months how important it was to remain committed to a portfolio despite the uncertainty. Patience was rewarded.
The above graph demonstrates the higher expected returns offered by small cap stocks and value (high-BtM) stocks in the US, non-US developed, and emerging markets. Note that the international and emerging markets data is for a shorter time frame. Small cap stocks are considered riskier than large cap stocks, and value stocks (as defined by a higher book-to-market ratio) are deemed riskier than growth stocks. These higher returns reflect compensation for bearing higher risk.
The above table shows that the average value and small cap premiums in the US equity market have persisted over various performance periods. The higher relative returns reflect compensation for bearing higher risk, as indicated by higher standard deviation. The value premium is defined as the difference between the average returns of value stocks and growth stocks (value minus growth). Value is defined as the top 30% of NYSE stocks by book-to-market ratio (high-BtM stocks); growth is defined as the bottom 30% of the NYSE by BtM (low-BtM stocks). The small cap premium is defined as the difference between the average returns of small cap and large cap stocks (or small minus large). The size breakpoint for small and large is the median NYSE market equity (i.e., the bottom 50% for small and top 50% for large).
Keep in mind that the table shows average premiums. For example, from July 1927 to June 2008, the returns of value stocks exceeded those of growth stocks by an average of 6.79% per year. This performance came with a 28.25% annual average standard deviation.
