Does Inflation Affect Index Returns? What Did Well Other Times When Inflation Was High?

Posted by Vident Financial on 10/22/21 9:30 AM

By any reasonable standard, inflation rates have been elevated this year. There is a debate about whether inflation will be transitory or not, but the debate is past whether there will or won't be an inflationary period coming out of the COVID crisis. There was, there is, and we're in it right now.


For reasons we have discussed previously, both market indicators and fiscal and monetary dynamics suggest that inflation might not be so transient after all.


High inflation doesn't just raise prices; it raises an important question for investors: Which investments historically tend to do relatively well during periods of elevated inflation?


First, we looked at various investment indices during different inflation environments. We looked at quarterly inflation data and identified those times when inflation was in the first quintile (meaning the highest fifth), and when it was in the lowest quintile (meaning the bottom fifth). Then, we calculated the average return for each index during those high inflation periods and during the low inflation periods.


First, let’s look at the high inflation periods.

High Inflation Period, All Index Returns-1

(Source: Bloomberg, St. Louis Federal Reserve, Bowyer Research)

Here are the indexes listed in the left-to-right order that you see above:

  1. Morningstar US Energy Sector
  2. Morningstar US Basic Materials Sector
  3. MSCI Emerging Markets Index (USD)
  4. Return Russell 2000® Growth Index
  5. Morningstar US Mid Growth Index
  6. Morningstar US Small Growth Index
  7. Russell Midcap® Index
  8. Morningstar Gbl Mkts xUS PR USD
  9. Morningstar US Small Cap PR USD
  10. Morningstar US Mid Cap PR USD
  11. Morningstar DM xUS PR USD
  12. Morningstar US Growth PR USD
  13. Russell 2000® Value
  14. Morningstar US Small Val PR USD
  15. Morningstar US Mid Val PR USD
  16. Morningstar US Large Growth PR USD
  17. S&P 500 Growth Index
  18. Morningstar US Large-Mid Value TR USD
  19. Copper Price Quarterly Change*
  20. Morningstar US Value TR USD
  21. Morningstar US Large Cap PR USD
  22. Morningstar US Large Value PR USD
  23. USREX - U.S. Diversified Real Estate IndexTM
  24. Vident Core U.S. Bond IndexTM
  25. Bloomberg US Agg Total Return Value Unhedged USD
  26. FTSE US Broad Investment-Grade Bond Index (USBIG®) 


It doesn't matter if you can't easily see which index is associated with which bar above. The point now is to get a sense of the degree of variability of these various investment indices during high inflation quarters. You can see that some investments have performed relatively very well on average during the high inflation quarters, and some have not. The chart above is not a comparison of how well an index does under a high inflation period in contrast with a low inflation period. All the data above occurs during high inflation. This is a comparison of index returns. On the left side are the indices that did best during high inflation, and on the right are the indices which did worst during high inflation. The above chart, unfortunately, tell us nothing about low inflation periods. But the following one does…

High and Low Inflation, All Index Returns-1

(Source: Bloomberg, St. Louis Federal Reserve, Bowyer Research)

Now we have a comparison of indices from best to worst performers in the period (the purple bars from left to right), and from high inflation environments to low inflation environments (represented in the purple bars in the background compared to the gray in the foreground). You can see that there is a general trade-off, though not a perfect one: Indices which historically do the best during inflation periods also tended to underperform during low inflation times, hence the gray bars. In investment, there's no such thing as a free lunch; but when lunches get expensive, there are some indices which are tastier than others.


Let's look next time at what might be on the menu if the inflation environment will be heating up.


*Created solely for this illustration, represents the price-per-ton of copper in global markets in dollars. This is not an established index.

Topics: inflation hedges

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