As the nearby graph illustrates, equities have provided a better hedge against inflation than other asset classes over time. The data in this graph is all pegged to a starting point of 100 on December 31, 1977, the earliest available observation for many of these data series. Since that starting point, the CPI index has risen to 422, an equivalent of 3.5% average inflation over this whole period. Gold and real estate have beaten inflation over the period analyzed, but there are a few points at which both of these asset classes have lagged inflation. Bonds – both Treasuries and corporates – have well outpaced inflation, but we need to remember that for most of this time bond yields were in a secular decline, creating capital gains in addition to the yield generated by the bonds. With interest rates at historically low levels, this dynamic will not recur to the same extent going forward, and bond returns will likely be lower in an environment of either stable or rising rates.
Equities over this period have compounded at an annualized rate of 9.3%, or to a total index level of 4,159 on the graph, from an initial start of 100, well ahead of inflation and the other asset classes analyzed. As the graph makes clear, this return has come at the cost of higher volatility, but equities have clearly provided the best option for longer-term investors eager to protect their portfolios against the damage of even modest inflation.
In addition to asset allocation, we find further inflation protection by seeking to invest in the equities of companies with certain characteristics that give them pricing power and allow them to pass on to their customers the effects of a general rise in prices, or a specific rise in their own input costs. Companies with strong balance sheets and healthy free cash flow tend to have the financial flexibility to adapt to uncertain economic environments. Companies that sell essential products and services to loyal customers often enjoy the recurring and predictable revenues that brand loyalty offers, while granting them the ability to exploit that loyalty by hiking prices when needed. None of this makes a company or its stock price immune from market cycles or rising inflation, but it does offer an added layer of inflation protection on top of asset allocation.
In his 1926 book “The Silver Stallion,” James Branch Cabell observes: “The optimist proclaims that we live in the best of all possible worlds; and the pessimist fears this is true.” Economic optimists are rightly cheered by the triple prospect of government stimulus, low interest rates and a surge in household spending. This powerful combination promises to drive an acceleration in economic activity and corporate profitability as 2021 unfolds. Pessimists agree with this outlook, and then extend it to a logical conclusion that ends in rising deficits, debts and inflation. As Cabell’s witty and insightful bot mot implies, both can be right.
We readily acknowledge that concerns about rising inflation have been unrealized for a long time: A monthly inflation report hasn’t topped 4% since 2008. We are nevertheless reminded of Aesop’s fable about the shepherd boy who delights in tormenting his fellow townsfolk by crying wolf, in order to send them scurrying about in fright before realizing that there is no wolf. They eventually wise up to the scam and start ignoring the boy’s cries. That’s when the wolf shows up and eats the boy.
There is light at the end of the long tunnel of health and economic concerns that have weighed on investors for the past year. We are glad to turn the calendar on 2020 and look forward to a better, stronger and healthier 2021, while at the same time keeping a wary eye on the old threat of inflation that might return to complicate the objective of preserving and growing wealth.
References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be and should not be interpreted as recommendations.