Does Inflation Affect Index Returns?

Posted: Sep 21, 2021 11:55 AM
Does Inflation Affect Index Returns?

Source: AP Photo/Pablo Martinez Monsivais, File

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.

(Source: Bloomberg, St. Louis Federal Reserve, Bowyer Research, as of 3/31/2021)

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

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

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 easily 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 comparison with a low inflation period. All of 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. This chart, unfortunately, tell us nothing about low inflation periods. But the following one does…

(Source: Bloomberg, St. Louis Federal Reserve, Bowyer Research, as of 3/31/2021)

Now we have a comparison of indices from best to worst (the purple bars from left to right), and from high inflation environments to low inflation environments (represented in the purple bars in the background 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.