What Is Inflation and What Can You Do About It?

What Are Inflation Expectations?

Research from Dimensional Fund Advisors shows that inflation expectations are incorporated in market prices. For example, when stock market returns or premium returns are examined relative to contemporaneous inflation, we see no reliable pattern:

Inflation and the Equity Premium
US inflation against contemporaneous Fama/French US Mkt-Rf Factor, 1927—2019
40%
20%
0%
-20%
-60%
-15%
-10%
0%
Annual Inflation, Year t
10%
1 sos

Source: DFA

We see similar results when comparing bond returns to levels of inflation.

An example of what the market is expecting for inflation is the 10-yr Breakeven Inflation Rate – this is the difference between the 10yr US Treasury and the 10yr US TIP. For example, the 10yr Treasury is yielding about 1.4% and the 10yr TIP is currently yielding about -0.8%, meaning inflation expectations are ~2.2% (this includes the inflation premium nominal bond holder demand for holding inflation risk, see exhibit below). If contemporaneous inflation is higher than what was expected, real yields on nominal bonds would be lower than real yields on TIPs. If contemporaneous inflation is lower than what was expected, then nominal bond holders would benefit relative to TIP holders. TIP/Real Return Bond holders give up the inflation risk premium.

Source: DFA

Protection from Unexpected Inflation

Investors that are highly sensitive to inflation may choose to invest in asset(s) that have returns that tend to move in the same direction as inflation, providing some purchasing power protection. Historical examples of these are Equities (not including REITs), Commodities, and TIPS/Real Return Bonds.

In Canada, the real return bond market is small relative to nominal bonds. Also, real return bonds in Canada tend to be issued with longer terms, for example, 30 years. A portfolio of Canadian real return bonds would likely be concentrated, have a long duration (15yrs+), and have a returns volatility profile similar to a stock portfolio.

Commodities also have a volatility profile similar to stocks, but with much lower historical returns:

Source: DFA

https://www.bankofcanada.ca/2020/08/understanding-inflation/

https://alphaarchitect.com/2021/04/15/inflation-and-the-value-premium/

https://rationalreminder.ca/podcast/150