Panorama: Guarding Against Inflation

First Republic Investment Management

During the past 100 years, inflation in the United States has averaged a little more than 3% annually. That may not sound like much, but if you purchased a basket of items in 1913 for $10, that same basket would cost you more than $234 today. Inflation, or a rise in the general level of prices within an economy over a given period of time, can threaten economic growth and real investment returns. As investors try to increase their purchasing power for the long term, inflation threatens this effort.

“Inflation is always and everywhere a monetary phenomenon.”

The most disruptive inflationary periods tend to occur when there are unanticipated spikes in prices that consumers, businesses and investors are unprepared to assume. Most inflationary spikes are associated with a supply shock— in the 1940s there were wartime controls placed on food, and in the 1970s food and energy supply shocks dramatically affected prices. Since the early 1980s, inflation in the U.S. has been declining or stable, and, in fact, the U.S. has not experienced double-digit inflation since 1981. Interest rates have declined accordingly during this time period, leading to the 30-year bond bull market investors have enjoyed.

Today, inflation concerns stem from an extremely accommodative monetary policy set by the Federal Reserve for the past five years. The conversation surrounding inflation has become louder in recent months as economic growth in the U.S. looks more sustainable. With the latest Consumer Price Index report showing annual inflation around 2%, we do not foresee an inflationary spike in the near term; however, a gradual increase in inflationary pressure could be just around the corner. For investors, inflation can have varying impacts on portfolio investments depending on many factors. Preparation, in the form of thoughtful diversification, may be instrumental in protecting portfolios through inflationary periods.

Our Outlook

As we mentioned above, our outlook does not foresee a spike in inflation or a large rise in interest rates in the near term. While the U.S. economy is showing signs of strength, the Federal Reserve continues to support lower interest rates across the yield curve by keeping short-term interest rates at near zero and by purchasing assets—$40 billion per month of agency mortgage-backed securities and $45 billion of long-term Treasury securities. Other factors that support our outlook for modest inflation include the following:

  • Unemployment remains stubbornly high at 7.7%, and wage pressures are minimal.
  • Capacity utilization data show a slack in productive capacity.
  • Europe, one of our largest trading partners, is still largely in recession from its debt crisis.
  • The U.S. dollar has been strengthening, putting pressure on commodity prices, which are priced mainly in U.S. dollars.

A key risk to our view is that inflation is clearly an issue right now in the major emerging countries of China, India and Brazil. Since we do participate in a globalized economy, those inflationary pressures may creep into our economy, especially if U.S. economic growth persists.

The Best Defense is a Good Offense

When structuring a portfolio to weather an inflationary period, it is important to understand how different assets act in this environment. Here is a quick guide:

  • Traditional long-term, fixed income portfolios may suffer price erosion, but short-term core and non-core debt strategies will be productive.
  • Private real estate, REITs and equities tend to protect purchasing power in the majority of low-and high-inflation periods.
  • Commodities and gold can sometimes produce the highest returns in inflationary times but are not as valuable in a portfolio as private real estate, REITs and equities in times of low inflation.
  • Currency diversification is valuable and can add stability to a portfolio during inflationary spikes.

Fixed-income markets are always the hot topic when inflation issues arise. Traditional investment-grade bond portfolios that feature U.S. government, municipal and corporate debt historically have shown negative correlation with inflation, implying that when inflation rises, these bonds prices are at risk.

There are specific concerns in today’s environment. Since the financial crisis of 2008, risk aversion and a desire for steady cash streams have led to an enormous amount of assets flows into bond funds. At the same time, the yields on these bonds have been driven to historical lows. Because of low rates, many investors have reached for yield by extending maturities. Bonds structured with longer-dated maturities (i.e., 10 to 30 years) are most susceptible to lose value when inflation and interest rates move higher.

Total Bond Fund Net Assets

Source: ICI Investment Company Institute—Net New Cash Flows All Bond and Income Funds, Rimrock Capital Management LLC

That being said, not all bonds are created equal. (See the companion article highlighting our Fixed Income outlook for more details.) Shorter-maturity bonds are less sensitive to inflation and higher interest rates. Floating rate notes and high-yield bonds can provide protection from rising rates although they carry other risks such as credit and liquidity. Specifically, Treasury Inflation-Protected Securities, or TIPS, also are a reasonable bond alternative to combat inflation due to their specific linkage with rising prices. Keep in mind that a well-managed fixed-income portfolio is an important part of a balanced portfolio for more reasons than yield. Despite low yields, high-quality fixed income offers greater downside protection than equities, REITs and commodities even in rising rate environments.

Equity investments, by contrast, protect purchasing power for the long term more effectively than fixed-income investments. Normally, companies have the ability to raise prices for their goods or services over time, leading to higher earnings and higher stock prices. For the short term, a spike in inflation can be disruptive to company earnings—with higher input costs hurting earnings growth.

The level of inflation present does make a difference, however. During low but rising levels of inflation (1-3% annually), stocks perform well because this generally is good for economic growth. On the other hand, once inflation rises above 6%, equities start to struggle as it is harder to pass along price increases and sustain returns on investment. Obviously, different sectors of the equity market will perform better than others. For example, natural resource companies may benefit from higher prices whereas companies that produce consumer staples from natural resources may be challenged to pass on price increases, therefore hurting earnings.

Since 1978, Real Estate Investment Trusts and commodities have provided the most dependable inflation protection in six-month periods of high inflation, with performance beating inflation more than two-thirds of the time, according to a study completed by NAREIT. Stocks were somewhat weaker, providing better returns than inflation in over 61% of the time. Surprisingly, the weakest inflation protector has been gold, with returns beating inflation during only 43% of high-inflation six-month periods. Equities and REITs stand out as good investments in both low and high-inflation environments whereas commodities and gold historically have provided near-zero returns when inflation is low.

Inflation Protection

Inflation Coverage During Six-month Periods of Relatively High Inflation, January 1978–January 2013

Source: Bloomberg

Inflation also has implications for the value of a currency. If inflation rises rapidly within a particular economy, it typically causes the currency there to weaken relative to others. However, as interest rates rise to offset inflation, the currency will stabilize. Countries go through different inflation and interest rate cycles at different times, so having exposure away from our base currency, the U.S. dollar, can be beneficial. Investing in foreign currencies backed by healthy, high-growth economies may be especially beneficial. For example, emerging market debt denominated in local currencies has correlated positively with inflation during the past
10 years due to currency effect, despite being fixed-income instruments. The currencies of many emerging economies with high GDP growth and moderate inflation levels have performed well for the past several years compared to major developed currencies, including the U.S. dollar.


While we do not see a spike in inflation coming soon, being proactive about potential inflation is important in structuring a portfolio. Moreover, being mindful of the fixed-income portion of the portfolio can provide value; focusing on the sectors of the fixed-income market and term structure is fundamental to protecting capital. Equity and real estate investments, both private and REITs, are core assets that also can protect purchasing power in both high and low inflationary environments. For additional inflation protection, some exposure to a basket of commodities, including gold, can be beneficial as well.

The views of the authors of these articles do not necessarily represent the views of First Republic Bank. First Republic Private Wealth Management encompasses First Republic Investment Management ("FRIM"), the Luminous Capital division of First Republic Investment Management, First Republic Trust Company ("FRTC"), First Republic Trust Company of Delaware LLC and First Republic Securities Company, LLC ("FRSC"), Member FINRA/SIPC. FRIM, FRSC and FRTC of Delaware LLC are subsidiaries of First Republic Bank. FRTC is a separate division of First Republic Bank.

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