Permanent Value

Week in Review (5/8/14)

Bruce Doole
May 8th, 2014

Analysis: How Inflation Affects a Portfolio

Portfolio Options

The past 20-plus years have provided generally favorable conditions for a 60/40 (stock/bond) portfolio. Interest rates have been in decline since 1982 — witness the 6.4% average annualized return for U.S. bonds since 1991 — and inflation has averaged 2.5% since 1991. Both of these factors provided a tailwind for bonds.

Yet should inflation and interest rates both begin to rise, U.S. bonds will face a stiff headwind. It will be vitally important to build multi-asset portfolios that include diverse ingredients that are more resilient to the headwind of rising rates and inflation — such as commodities and real estate. The venerable, but underdiversified, 60/40 portfolio is not positioned to thrive during such conditions.

Among the portfolio options, the inflation-adjusted performance of the 60/40 portfolio was devastated during periods of high inflation, dropping to a median net return of 2.67% from a median gross return of 9.46%. During the more favorable periods of low inflation, the 60/40 portfolio showed a much smaller difference between gross and net performance, with an 11.86% gross return vs. a 9.37% net return.

The 60/40 portfolio is highly vulnerable to inflation because of the 40% allocation to bonds, which suffer in periods of high inflation. The inflation-adjusted performance of the seven-asset portfolio shows more downside protection in times of high inflation, largely because of the inclusion of commodities: Its median gross return of 13.68% in high inflation periods fell to a more manageable 6.66% when adjusted for inflation.

Inflation’s Impact

It’s impossible to evaluate asset class performance without factoring in the impact of inflation on returns. When inflation is factored into performance, every asset class — and both portfolios — had higher net returns during periods of low inflation except one: commodities. The inflation-adjusted net performance of commodities was 18.31% during periods of high inflation — surprisingly close to the asset class’ 24.66% gross performance during periods of high inflation.

The net returns of U.S. bonds also suffered greatly when inflation was high. Notice that when inflation was high, U.S. bonds had gross returns of 7.4% but inflation-adjusted returns of only 2.18%. The real-world (net) performance of U.S. bonds obviously favors periods of low inflation and is hurt during periods of high inflation.

The inflation-adjusted performance of real estate is also better during periods of low inflation, whereas gross returns were basically the same during high and low inflation.

This Week’s Economic Data

Jobless claims rose to 344,000 for the week of April 26.

The ISM Manufacturing Index rose 1.2 points to a better-than-expected level of 54.9.

The unemployment rate fell to 6.3% in March.

 

Source: Financial Planning Magazine/ Ivy Fund