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Investing has been a reliable way to compound one’s inheritance over ages known throughout human history. But different monetary and fiscal situations, especially during times of uncertainty and extreme stress, force both individuals and institutions to adjust their financial habits. A recent research paper written by Guido Baltussen, Laurens Swinkels, and Pim van Vliet analyzed large samples of data starting from the 19th century and brought unique perspectives on how various asset classes perform during “quiet, good” periods and, on the other side, economic turmoil. Research summarized very actual topics of investing during those different cycles and what inflation does to returns across equities, bonds, and cash.
We would like to highlight some points we find most interesting and useful: Firstly, let’s define real returns as nominal returns minus inflation. Equities and bonds, on average, yield lower nominal returns during periods of high inflation (inflation > 4%), causing negative real returns. Further, equity returns tend to be relatively low in nominal terms in periods of deflation (inflation < 0%) but average in real terms. Stagflationary episodes with both high inflation and economic downturns (i.e., recessions) are truly bad times for investors; for example, nominal equity returns average -7.1% per annum, yielding double-digit negative returns in real terms.
In case you’re interested, we advise you to take a look at the presented tables from the last pages of the paper. Especially worth mentioning is a closer look at Table 3, which is both a great and very easily understandable summary of both nominal and real results from investing during those mentioned regimes. In addition, supplementary appendix tables provide useful robustness tests that confirm statistically significant results.
Authors: Guido Baltussen, Laurens Swinkels, and Pim van Vliet
Title: Investing in Deflation, Inflation, and Stagflation Regimes
We examine asset class and factor premiums across inflationary regimes. As periods of high inflation and deflation are relatively uncommon in recent history, we use a deep sample starting in 1875. Moderate inflation scenarios provide the highest returns across asset class and factor premiums. During deflationary periods, nominal returns are low, but real returns are attractive. By contrast, real equity and bond returns are negative during a high inflation regime, and especially so during times of stagflation. During these ‘bad times’ factor premiums are positive, which helps to offset part of the real capital losses.
As always we present several interesting figures:
Notable quotations from the academic research paper:
“We start our analysis by examining asset class (equities, bonds, and cash) returns and factor returns within and across asset classes over our deep sample. We show the global equity return has been on average 8.4% (in arithmetic terms) between 1875 and 2021, while the global bond market return (currency risk hedged) has been 4.5%. For comparison, global inflation has been on average 3.2% per annum over the same period. Value, Momentum, Low risk or Quality/Carry factors also returned attractive and significant returns above 4%, providing substantial alpha over traditional asset classes. The average multi-factor factor combination delivers significant alphas on top of asset returns with t-values above 7.9 over this full sample period. In other words, asset class and factor returns are strong and consistent ‘empirical facts’, with factor premiums offer materially value added to asset class premiums. Next, we consider annual investment performance over various inflationary regimes. In our core analyses we divide our sample in various ex-post inflation regimes and examine the average returns during each regime. As our base-case we divide our sample in four economically motivated global inflation regimes: (1) below 0%, or deflation, (2) between 0% and the current central bank target of 2%, (3) a mild inflation overshoot, between 2% and 4%, and (4) high inflation, above 4%. Note that this is more granular than the high/low inflation regime with an entry threshold of 5% as used in Neville, Draaisma, Funnell, Harvey, and Van Hemert (2021).4 Each of our four regimes constitutes about 20% to 30% of the observations.
Deflationary periods, where inflation is below 0%, coincide with relatively low nominal returns for equities of 2.4% per annum, well below the 8.4% unconditional average return. Bonds and cash show a 5.2% and 2.8% per annum nominal return during deflationary periods, which is slightly above the unconditional average of 4.5% and 3.4%. Consequently, a multi-asset 60/40 investor achieved a 3.5% nominal return during deflationary periods. However, an investor that does not suffer from money illusion realizes that even though the nominal return is low, the real return is decent because of the deflation. Adjusted for purchasing power, the multi-asset investor earns 6.7% per annum during deflationary periods. Inflationary periods, where inflation is above 4%, show a positive nominal returns for equities (6.9%) and bonds (3.9%). At face value, it may seem that the multi-asset investor does quite well with a 5.7% nominal return. However, the real return is substantially negative at -2.9% per annum, leading to a severe reduction in purchasing power.19
In sum, our findings show asset class premiums vary significantly across the inflationary regimes in nominal and especially real terms. Equities and bond on average yield lower nominal returns during periods of high inflation, causing negative real returns. By contrast, equity, bond, and global factor premiums are generally consistent across inflationary regimes, displaying generally no significant variation across, while they enhance nominal and real asset class returns in (approximated) long-only asset class implementations.
The average returns per inflationary sub-regime are displayed in Table 4. Panel A1 (A2) of Table 4 shows that nominal (real) returns on equities are particularly bad during recessions with high inflation, or stagflationary episodes. The nominal (real) return on the multi-asset portfolio is -2.2% (-11.7%) per annum, compared to 8.2% (-0.1%) during expansionary periods with high inflation. Recessions likely lead to lower expected corporate cash flows, which dominate a decrease in the discount rate, leading even to negative nominal stock returns of -7.1% per annum (see Table 4, Panel A1). Recessionary periods are somewhat better for nominal bonds than expansionary periods with nominal returns of 5.1% versus 3.6% per annum (see Table 4, Panel A1). Decreasing interest rates lead to positive marked-to-market gains. The negative real return for equities of – 16.6% suggests that equities are a particularly bad inflation hedge during stagflationary periods. While expansionary periods in general tend to be good for investors, this does not hold when inflation is high. Real returns on stocks are marginally positive (2.9% p.a.) and real returns on bonds are deeply negative (-4.7%). Even though the economy is doing well, times of high inflation are generally not good for investors.
However, asset class premiums vary substantially across inflationary regimes. Deflationary and moderate inflation scenarios generally provide positive nominal and real equity and bond returns, while especially real returns suffer during times of high inflation. Splitting up inflationary regimes into sub-regimes reveals that stagflationary episodes, inflationary bear markets or rising inflationary times, and to a lesser extent deflationary bear markets, are bad times for investors. During these ‘bad times’, equity, bond, and global factor premiums are consistent and attractive, as they are across inflationary regimes. As such factors help to alleviate the pain during bad times, offsetting some of the negative impact of high inflation. These results have three implications. First, for investors times of high inflation, and especially stagflation and inflationary bear markets are challenging, which suggests asset class returns may partly provide a compensation for bearing risks during these bad times. Second, as equity, bond, and global factor premiums are generally consistent across inflationary regimes, they provide consistent value add for traditional portfolios. These premiums provide diversification, but at the same time are also not a perfect hedge against inflation, as their returns do not substantially increase during the worst times. Finally, our results suggest factor premiums in equities, bonds, and across asset classes are not a compensation for bearing inflationary risks.”
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