Module III·Article IV·~3 min read
Inflation and Investments: Real Return
Inflation, Deflation, and the Price Level
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Inflation and Investment Returns
Inflation has a fundamental impact on investment returns, eroding the purchasing power of nominal incomes. Understanding the difference between nominal and real returns, as well as the impact of inflation on various asset classes, is a key skill for an investor.
Nominal and Real Return
Nominal return is the return expressed in monetary units without considering changes in purchasing power. Real return is nominal return adjusted for inflation, reflecting the change in real purchasing power. Approximately, the real return is calculated as the difference between nominal return and the inflation rate:
$
r \approx i - \pi
$
where $r$ is the real return, $i$ is the nominal return, and $\pi$ is inflation. The precise formula accounts for the multiplicative effect:
$
(1 + r) = \frac{1 + i}{1 + \pi}
$
For long-term investments, real return is a more significant indicator than nominal. High nominal return during high inflation may mean a negative real return and loss of purchasing power.
Fisher Equation
The Fisher equation connects nominal and real interest rates with inflation expectations:
$
i = r + \pi^e
$
where $i$ is the nominal rate, $r$ is the real rate, and $\pi^e$ is expected inflation. This equation has important practical implications. Nominal rates should compensate investors for the expected loss of purchasing power due to inflation. If inflation expectations rise, nominal rates must increase to maintain the same real return. The breakeven inflation rate—the difference between the yield of nominal and inflation-indexed bonds—reflects market inflation expectations and is actively used by investors for monitoring them.
Impact of Inflation on Asset Classes
Fixed-rate bonds are the most vulnerable assets to inflation. Inflation growth reduces the real value of fixed coupons and principal, and also leads to an increase in nominal rates and a decline in bond prices. Long-term bonds are more sensitive due to their greater duration.
Inflation-indexed bonds (TIPS, OATei, etc.) protect against inflation since their principal and coupons are adjusted for actual inflation. However, they do not protect against rising real rates.
Stocks are traditionally regarded as inflation hedges in the long run, as companies can raise nominal prices and profits. However, in the short term, inflation can negatively affect stocks through an increase in discount rates, margin compression, and uncertainty.
Commodities often benefit from inflation, especially if caused by supply shocks in raw materials. Commodity indices have historically shown a positive correlation with unexpected inflation.
Real estate and infrastructure provide a certain hedge against inflation due to the ability of rents and rates to rise with inflation. However, they are vulnerable to the rise in real interest rates.
Sector Beneficiaries and Those Affected
In high inflation conditions, sectors with pricing power and the ability to pass rising costs on to prices win relatively: energy, materials, consumer staples. Commodity producers benefit from the growth in prices for their products.
Sectors with a high share of fixed costs and limited pricing power lose out: utilities with regulated tariffs, retail with high competition, companies with long-term fixed-price contracts.
The financial sector has an ambiguous relationship with inflation. Banks can benefit from the rise in nominal rates (improved net interest margin), but lose from the depreciation of their loan portfolio and an increase in defaults.
Investment Strategies in Inflationary Conditions
Protection from inflation can be achieved in several ways. Diversification across asset classes, including real assets (commodities, real estate, infrastructure), reduces portfolio sensitivity to inflation surprises. Reducing bond portfolio duration decreases sensitivity to rising rates. Including inflation-indexed bonds provides direct protection from inflation. Selecting stocks with pricing power and low capital intensity increases resilience to inflation. Companies with low debt benefit from the devaluation of nominal obligations but lose from higher refinancing costs.
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