Will inflation hurt stock returns? Having a thoughtful approach may help.
Rising consumer prices over the past couple of years have left many investors weighing options for insulating their portfolios against possible future inflation. But the historical data has good news for equity investors: Inflation isn’t necessarily bad news for stocks. In fact, stocks have historically managed to outpace inflation over the long haul.
A look at equity performance over the past three decades reveals substantial fluctuation in year-to-year U.S. stock returns, but not in a way that’s reliably connected to inflation. The highest inflation year in the sample, 2021, coincided with strong positive returns even after accounting for the impact of inflation. In fact, 23 of the past 30 years saw positive real (or inflation-adjusted) returns for U.S. stocks.
The real thing
S&P 500 Index annual real return vs. inflation
Source: S&P data, Dow Jones Indices LLC, U.S. Bureau of Labor Statistics, 2023. Short-term performance results should be considered in connection with longer-term performance results. Investing risks include loss of principal and fluctuating value. There is no guarantee an investment strategy will be successful. Indexes are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. In U.S. dollars. Real returns illustrate the effect of inflation on an investment return and are calculated using the following method: [(1 + nominal return of index over time period) / (1 + inflation rate)] − 1. Past performance does not guarantee future results.
Over the period charted (1993 to 2022), the S&P 500 Index posted an average annual return of 8.5% after adjusting for inflation. Going all the way back to 1926, the average annual inflation-adjusted return for the index was 8.7%. This long-term view is informative because it covers a wide variety of market environments, including periods with double-digit U.S. inflation (like the 1940s and 1970s) as well as periods with deflation (like the Great Depression, 1929 to 1932).
Equities in developed markets outside the United States and emerging markets have tended to outpace U.S. inflation over the long term as well. In their 2021 paper “U.S. Inflation and Global Asset Returns,” Wei Dai and Mamdouh Medhat find that developed ex-U.S. and emerging-market equities had positive inflation-adjusted returns on average over the period 1991 to 2020.1 The historical and international data shows the power that diversified global exposure to stocks and long-term investing can have in mitigating the impact of inflation for investors.
But the good news doesn’t end there. An asset allocation with a systematic emphasis on stocks with higher expected returns may further improve the odds of outpacing inflation. For instance, categorizing U.S. stocks into style groups based on market capitalization and relative price, we see that small-cap value stocks have had an average annual return of 15.0% after inflation going back to 1926, almost twice the 8.4% average annual return for large-cap growth stocks over that same period.
Outpacing inflation
Average annual real returns for U.S. stocks, 1927–2022
Source: Dimensional Fund Advisors, 2023. Fama/French Indices represent academic concepts that may be used in portfolio construction and are not available for direct investment or for use as a benchmark. Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment. U.S. inflation is the annual rate of change in the Consumer Price Index for All Urban Consumers (CPI-U, not seasonally adjusted) from the Bureau of Labor Statistics. See Index Descriptions in the appendix for descriptions of the Fama/French index data. Returns are in U.S. dollars. See the Data Appendix for additional information. Actual returns may be lower. Past performance does not guarantee future results.
Aiming to outpace—or hedge?
Asset prices incorporate information quickly and reflect the collective forward-looking expectations of market participants, including expectations of future inflation. So inflation concerns are really about the negative impact of unexpected inflation on the real value of invested wealth. An asset is therefore most useful as an inflation hedge when its nominal returns move closely with unexpected inflation.
However, across a broad range of securities, our research has found that correlations between nominal returns and unexpected inflation aren’t very strong. For the few exceptions where the correlation is reliable, such as for energy stocks and commodities over the period 1991 to 2022, the nominal returns for these assets have been around 15 times as volatile as inflation, and a large proportion of their nominal return variation has been unrelated to inflation. The annual nominal returns to energy stocks and commodities differ dramatically from the annual realizations of inflation. If the goal is to reduce the variability of future purchasing power, it’s questionable that hedging with something as volatile as these types of investments will effectively achieve that.
One of these things isn't like the others
Annual U.S. inflation and nominal returns to energy stocks and comodities, 1991–2022
Source: Dimensional Fund Advisors, 2023. Fama/French Indices represent academic concepts that may be used in portfolio construction and are not available for direct investment or for use as a benchmark. Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment. See Index Descriptions in the appendix for descriptions of the Fama/French index data. Returns are in U.S. dollars. See the Data Appendix for additional information actual returns may be lower. Past performance does not guarantee future results.
The takeaway for investors? History suggests that staying the course with stocks may help investors keep pace with rising prices. Stock strategies, like multifactor ETFs, that tilt toward sources of higher expected return may further boost the chances of reaching one’s financial goals.
1 “U.S. Inflation and Global Asset Returns,” Wei Dai and Mamdouh Medhat, Dimensional Fund Advisors, July 13, 2021. https://ssrn.com/abstract=3882899.
Data appendix
Data appendix
U.S. inflation
The annual rate of change in the Consumer Price Index for All Urban Consumers (CPI-U, not seasonally adjusted) from the Bureau of Labor Statistics.
U.S. equity portfolios and factors
The U.S. industry portfolios are the 12 Fama/French industry portfolios. The U.S. style portfolios (small cap value and growth and large cap value and growth) are from the Fama/French six portfolios sorted on size (market cap) and book-to-market equity. The returns to all of the above are from Ken French’s data library: https://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html.
Index descriptions
Fama/French U.S. Small Growth Research Index: Provided by Fama/French from CRSP securities data. The index includes the higher 30% in price-to-book of NYSE securities (plus NYSE AMEX equivalents since July 1962 and NASDAQ equivalents since 1973) that have smaller market capitalization than the median NYSE company. It is not possible to invest directly in an index.
Fama/French U.S. Small Value Research Index: Provided by Fama/French from CRSP securities data. The index includes the lower 30% in price-to-book of NYSE securities (plus NYSE AMEX equivalents since July 1962 and NASDAQ equivalents since 1973) that have smaller market capitalization than the median NYSE company. It is not possible to invest directly in an index.
Fama/French U.S. Large Growth Research Index: Provided by Fama/French from CRSP securities data. The index includes the higher 30% in price-to-book of NYSE securities (plus NYSE AMEX equivalents since July 1962 and NASDAQ equivalents since 1973) that have larger market capitalization than the median NYSE company. It is not possible to invest directly in an index.
Fama/French U.S. Large Value Research Index: Provided by Fama/French from CRSP securities data. The index includes the lower 30% in price-to-book of NYSE securities (plus NYSE AMEX equivalents since July 1962 and NASDAQ equivalents since 1973) that have larger market capitalization than the median NYSE company. It is not possible to invest directly in an index.
Important disclosures
John Hancock ETFs are distributed by Foreside Fund Services, LLC in the United States, and are subadvised by Dimensional Fund Advisors LP. Foreside is not affiliated with John Hancock Funds, LLC or Dimensional Fund Advisors LP.
The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. It is not possible to invest directly in an index. Their performance does not reflect the expenses associated with the management of an actual portfolio. Diversification does not guarantee a profit or eliminate the risk of a loss. Past performance does not guarantee future results.
There is no guarantee investment strategies will be successful. Investing involves risks, including the potential loss of principal. There is always the risk that an investor may lose money. A long-term investment approach cannot guarantee a profit.
All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.
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