Inflation has caused plenty of angst at grocery stores, lumber yards and even concert venues over the past four years. Back in May of 2020, consumer prices were basically flat compared with a year earlier. By June of 2022, the annual inflation rate had soared to 9.1%, then started cooling so that overall prices in December 2023 were 3.4% higher than the year before. That's close to the 40-year average of 2.9% but still not ideal.
Inflation can wreak havoc with your portfolio, too. "Inflation impacts your portfolio in acute and obvious ways and in more sneaky and nefarious ways," says Wylie Tollette, chief investment officer of Franklin Templeton Investment Solutions and coauthor of a 2022 study on which kinds of investments do best in inflationary times.
Inflation erodes the value of your investments by reducing their purchasing power, for starters. And when inflation is on the rise, central bankers tend to respond with higher interest rates to cool the economy and put a lid on prices. The Federal Reserve, for example, has hiked its benchmark rate 11 times since March 2022. The one-two punch of higher inflation and rising rates sent stocks and bonds reeling, making 2022 the rare year in which both markets tanked.
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More subtly, inflation rates can also influence overall market valuations, or the prices investors are willing to pay for financial assets. In general, the higher the inflation rate, the less investors are willing to pay for stocks.
One rule of thumb states that stocks are overvalued if the average price-to-earnings (P/E) ratio for stocks overall is higher than 20 minus the inflation rate. Based on a 2024 expected inflation rate of about 3%, that implies a fair value for the S&P 500 index would be about 17 times expected earnings. As of January 31, the S&P 500 index traded at a P/E of 21.7, but that's skewed higher by a handful of giant growth stocks known as the Magnificent Seven.
Likewise, investors are generally willing to lock money up in a bond only if they think the bond's interest rate will beat inflation over its lifetime. "It's all about inflation expectations," explains Rob Arnott, founder of the investment firm Research Affiliates.
As bad as inflation can be, stagflation (when inflation is rising but the economy is in a rut) can be worse – as can deflation (when widespread, persistently falling prices threaten to destabilize the economy overall). Economists say there are basically five different pricing environments, or kinds of "flation," each impacting your portfolio in different ways. They're listed below with summaries of which types of investments tend to prosper in each.
Inflation
A little bit of inflation, which is a sustained increase in the price level of goods and services, is generally considered beneficial for the economy. But when prices start rising by more than about 2% a year, policymakers, bankers and businesspeople worry.
Business managers, fearing their revenues will lag, often start raising prices, and workers demand raises, potentially sparking a dangerous upward cycle. The investments that have historically beaten high inflation include energy stocks, residential real estate held directly (real estate investment trusts have provided much less inflation protection in previous cycles) and Treasury inflation-protected securities. TIPS are federal IOUs that adjust their principal in line with the Consumer Price Index (CPI).
Commodity funds also tend to beat inflation. For example, the TCW Enhanced Commodity Strategy (TGABX), a member of the Kiplinger 25 list of our favorite no-load mutual funds, returned 44% in the most recent period of rising inflation, from March 2021 through May 2022.
Stocks in general can be a poor inflation hedge over short periods but serve as potent protection for investors willing to buy and hold for more than five years, Tollette says. Fixed-rate bonds typically underperform during high-inflation periods.
Disinflation
When the rate at which prices are rising slows, you get disinflation, which is what we have now. During disinflation, unlike in deflationary periods, prices still go up – sometimes painfully. The important distinction is that they are climbing more slowly than in the recent past.
The good news is that a moderation of inflation, such as the cooling that the economy experienced in 2023, is typically a boon for investors because it bodes well for corporate profitability and thus stock prices. During these periods, investors are often rewarded for taking more risks, such as buying stock in growth-oriented companies.
Since inflation started declining in July 2022, the growth-oriented Nasdaq Composite index has handily beaten broader measures, such as the S&P 500, for example. Declining inflation also means that bonds bought during the more inflationary period now promise higher "real," or inflation-adjusted, returns. Commodities, however, have done poorly in previous periods of disinflation.
No-flation
Periods of price stability (typically defined as times when consumer prices overall rise by no more than 2% a year) are sometimes referred to as "no-flation." They tend to be a "golden era for financial assets," says Gary Schlossberg, global strategist for the Wells Fargo Investment Institute.
Think back to 2013 through 2019, when the Consumer Price Index generally stayed below 2%. The S&P 500 notched gains in six of those seven years and produced an above-average annual return of 13.6%. Price and economic stability create a good climate for just about all investments but especially for riskier investments, such as growth-oriented and small-company stocks, Schlossberg says.
Deflation
The prices of some items, such as computers, gasoline and seasonal foods, drop from time to time. But a generalized, economy-wide drop in prices, or deflation, is rare. That's good, because deflation can lead to a vicious cycle: A weakening economy leads to lower wages, layoffs and decreased spending, which in turn ushers in still-lower prices and a further weakening of the economy.
The U.S. has seen general deflation only twice in the past century: During the Great Depression in the early 1930s and from March through October of 2009, partly overlapping what many call the Great Recession. In both periods, stock prices initially plunged much more than consumer prices and took years to recover. Volatile commodities also tend to suffer during deflation. Bonds that pay a fixed, positive rate of interest offer positive real returns, barring a default.
Stagflation
Inflation that coincides with stagnation in the job market and the economy, known as stagflation, causes truly challenging times for investors. Because economic weakness often prevents companies from raising prices enough to recover their costs, profits shrink, and stock returns fail to keep up with inflation.
From 1973 through 1982, the annual inflation rate averaged 8.7% and the average unemployment rate topped 7%. But the annual average return of the S&P 500 over that period was just 6.7%, meaning investors lost purchasing power. The economy escaped a stagflation scare during the pandemic.
If you want to hedge against this type of painful economic malaise, Tollette says your best bet is TIPS, which, if you hold to maturity, are guaranteed to return your investment and move up with inflation.
Note: This item first appeared in Kiplinger's Personal Finance Magazine, a monthly, trustworthy source of advice and guidance. Subscribe to help you make more money and keep more of the money you make here.
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