Is High Inflation A Returns Killer?

I’m sure you’ve noticed over the last year that filling your grocery cart is costing considerably more, even though what you’re buying probably hasn’t changed much. This isn’t something you’re imagining; Statistics Canada recently published the 12–month change in the Consumer Price Index (CPI) for the end of April which came in at a whopping 6.8% – a 31-year high. For those unfamiliar with the Consumer Price Index (CPI), it represents changes in prices as experienced by Canadian consumers. The CPI measures price change by comparing, through time, the cost of a fixed basket of goods and services.

6.8% is a big jump in the cost of living especially given inflation has hovered around the 2% mark for the last decade. You may be wondering whether stock returns will suffer if inflation keeps rising. Here’s some good news: Inflation isn’t necessarily bad news for stocks. Since 1992, one–year returns on stocks have fluctuated widely. Yet the weakest returns can occur when inflation is low, and 23 of the past 30 years saw positive returns even after adjusting for the impact of inflation.

Stocks vs. Inflation
S&P 500 1Year Real Return vs. US Consumer Price Index

 

Over the period charted, the S&P 500 posted an average annualized return of 8.1% after accounting for the impact of inflation. The annualized inflation-adjusted return on US stocks is 7.3% when going all the way back to 1926. Long story short: history suggests that stocks tend to outpace inflation over time.

Rising Rates and Fixed Income: Short-term Pain, Long-term Gain

If the economy is growing quickly or inflation is too high, a country’s central bank will use interest rate increases as a tool for slowing the pace of price changes. With central banks raising rates globally, we’ve seen bonds come under pressure after a long period of positive returns. That’s because bond prices have an inverse relationship with interest rates – this means that when interest rates go up, bond prices go down.

Calendar Performance of Fixed Income Index

DFA Canada Global Fixed Income Portfolio Custom Benchmark 

It’s important to look past the recent poor performance of fixed income and remember that price changes represent only one component of the returns generated in your fixed income portfolio. Because interest income is the primary driver of bond returns, the ability to reinvest into a gradually rising rate environment can help build long-term growth. When rates rise, new bonds in your portfolio pay a higher coupon, increasing the income you receive in the future.

Annualized Returns of Bonds During Periods of Rising Rates

Performance of Dimensional’s Global Core Index

As you can see by the graph above, bonds have delivered positive annualized returns during the most recent periods of rising central bank rates. This is because the increase in the income a bond produces also helps to offset the negative impact on its declining price – often quite quickly. Despite the short-term pain that can accompany periods of rising rates, as fixed income investors you should welcome the prospect of higher interest rates because ultimately, they’re a long-term positive.

As always, if you have any questions about the above or would like to talk about your portfolio, please reach out to us.

Sincerely,

Danielson Group Wealth Management
Assante Capital Management Ltd.

All graphs shown above are from the Dimensional Returns web.

This material is provided for general information and is subject to change without notice. Every effort has been made to compile this material from reliable sources however no warranty can be made as to its accuracy or completeness. Before acting on any of the above, please make sure to see a professional advisor for individual financial advice based on your personal circumstances.