Rodrigo De La Peña Alanis
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Inflation has been at the forefront of the minds of many investors in recent months as higher price levels have resulted from economic reopenings and supply chain dislocations across the globe. For instance, the consumer price index — which measures the cost of a basket of goods purchased for consumption by urban households in the United States — rose 0.4% during the month of September, coming in slightly above expectations and translating to a 5.4% jump on a year-over-year basis. Notably, the yearly spike in the CPI is the most significant in over a decade. While the debate on whether current inflation levels are transitory in nature or pose a longer-term threat to the economic health of the world is of great importance and will clearly continue for some time, the question of how investors can mitigate risks stemming from price level increases through the use of different asset classes is also worth exploring.
Real assets, including commodities and real estate, are known to be robust inflation hedges due to the fact that input costs, along with property values and rental income streams, tend to rise in tandem with overall price levels. The case for equities as a guard against higher inflation can be argued by pointing out that revenues and earnings of companies with inelastic demand for their goods and services may also rise along with inflation, due to the fact that firms with strong customer bases are able to pass on price increases to end consumers with relative ease. Generally speaking, this argument has held true in recent decades, as U.S. equity indices have tended to appreciate during inflationary periods going back to the late 1970s. Specifically, and as displayed in this week’s chart, equities have demonstrated hedge-like performance characteristics during periods of moderate inflation (CPI increases of 1–10%) and have largely generated positive real returns during those time frames. It is important to note that recent performance trends are likely aberrational, as equity indices have bounced back quite strongly after pandemic-induced troughs that occurred around the same time as the beginning of the current inflationary period. During times of significant inflation (CPI increases of 10% and above), equity performance has been more mixed, with returns of various style indices usually positive (though often coming in below the prevailing inflation rate). Regardless of whether or not the current inflationary regime is transient or long-term in nature, the data clearly indicate that equities can play a role in helping to lessen the impact of price level increases on the purchasing power of investment portfolios. Prudence and diversification across the asset class spectrum can also help investors endure elevated inflation levels that may persist into the near future.
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