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Key takeaways:

• There is no risk-free way to consistently beat inflation but, now real yields on inflation-linked government bonds are positive in most developed markets, investors with a defined horizon have a better probability of doing so.

• Short-dated inflation-linked bonds offer the best chance of matching near-term inflation, in our view, if starting real yields are positive; longer maturities offer higher yields but may not match inflation in the short term.

• Equities, commodities and real estate can provide long-term inflation protection but can also be volatile over the short to medium term. There are no guarantees and an investor’s entry price will matter greatly.

• We think investors with a multi-year investment horizon can be hopeful of beating inflation based on current real yields, but to do so by more than 1% per annum requires accepting greater risk and uncertainty. 

Investors wanting to protect their wealth in real (inflation-adjusted) terms over both an annual and multi-year horizon face an inevitably uncomfortable conclusion: there is no risk-free solution. The good news is that today, unlike five years ago, the real yields on inflation-linked government bonds are now in positive territory for most developed markets. Therefore, investors with a matched liability or a specified investment horizon can at least be almost certain of beating inflation over their chosen time frame. Bruising experience As the experience of the last few years demonstrates, inflation-beating returns are sometimes hard to come by when passively holding long-only market exposures. This can even be the case when the asset is explicitly linked to inflation, as holders of longer maturity inflation-linked bonds (linkers), property or infrastructure assets will attest.

US Treasury Inflation-Protected Securities (TIPS), US Treasuries and cash* vs. inflation, rebased.

The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast, nor a recommendation to purchase or sell any particular security. Marketing Communication. For Professional Investors only. 

It is hard to protect against inflation in all scenarios because no asset can guarantee inflation-beating returns on a mark-tomarket basis. This is true even for inflation-linked bonds, because the real yield required by market participants changes over time. Other assets, such as equities, property, commodities, credit or conventional bonds, may match or typically beat inflation over time, but are volatile and can disappoint over shorter time horizons. Investors in short-dated inflation-linked bonds, if the starting point real yield is positive, have the best chance of guaranteeing a return that at least matches inflation in the near-term, in our opinion. In the major developed economies (Japan excepted) such real yields are currently in the region of 0-1%.

Real yields tend to be low on short-dated inflation-linked bonds

On a 1-year horizon, a similar maturity inflation-linked bond should beat inflation if the starting point real yield is positive but probably not by much given the asset’s defensive nature. There is also the issue of re-investment risk if subsequent real yields are lower or negative. Moreover, if inflation is surprisingly low, the investor in short-dated linkers may outperform inflation but underperform cash.

Investors looking to beat inflation over longer time horizons can buy longer maturity inflation-linked bonds, where real yields on offer are typically higher, but as noted above such bonds do not guarantee inflation-beating returns over shorter run periods if the required real yield moves higher. Of course, if matching a long-term liability, shorter term price moves should not be a concern to the investor.

Longer maturity bonds typically offer higher real yields

Inflation-PLUS!

Today, risk-averse investors have a good chance of protecting wealth in real terms by investing in inflation-linked bonds. But many long-term investors have higher return objectives such as inflation plus-3/4/5%. Given that such required returns are above the real yield-to-maturity of most government bonds what should they do?

Equities have delivered real returns well in excess of inflation for most of the major markets, although they are volatile and come with no guarantee. Adjusted for inflation, the return from equities was very poor in the 1970s (albeit, better than bonds) and in the early 2000s. Commodities are another plausible but sometimes unreliable option, and returns may vary significantly simply based on how a basket is weighted. While gold has performed very well in recent years, it declined in value by 83% adjusted for inflation from 1980 to 2000. Similarly, the real price of West Texas Intermediate crude oil is 42% lower today than it was 20 years ago. For other real assets, such as real estate or infrastructure, the story is similar: they can provide long-term inflation protection but considerable volatility over the short to medium term. There are no guarantees and an investor’s entry price will matter greatly.

Gold declined in value between 1980 and 2000, in real terms

The oil price has declined since 2005, in real terms

Today’s landscape

Our starting point for assessing potential asset class returns is to look at available “real yields”, proxied by the earnings yield for equities and by adjusting nominal bond yields for the long-run consensus expected for inflation. Such measures are clearly only a guide, as opposed to a precise estimate, but we believe they have some merit and predictive power when it comes to forming long-run expected returns.

We have not included commodities in this framework since they do not provide a yield, nor other real assets that may be more sector-specific in nature.

Cross asset valuation

In aggregate, current valuations look relatively neutral, in our view, if consensus inflation and earnings expectations turn out to be roughly right: bonds and a globally diversified basket of equities would be expected to beat inflation over the medium to long term. The combined real yield of a 60-40 blended portfolio of equities and bonds is certainly more attractive than was the case in 2021, when such portfolios performed very poorly the following year. That said, a worse than expected outcome for inflation or corporate profits would likely be challenging for long-only investors.

A 60/40 portfolio of equities and bonds could beat inflation over the medium term

What can investors do to beat inflation?

We think investors today, with a multi-year investment horizon, can be hopeful of beating inflation with passive exposures based on starting point real yields. At the same time, they must accept that doing so by more than 1% or so per annum over a multi-year time horizon requires investing in uncertain outcomes with potential returns that may be much better – or worse – than expected. Adding further diversification by including other assets does not change the conclusion.

Any investor first needs to define their time horizon and their attitude to risk. Rather than volatility, our preference is to think of true risk as “the risk of permanent loss of capital or an inadequate return”, to quote Charlie Munger, the legendary investor, who was vice chairman of Berkshire Hathaway. The investor who is willing to tolerate short-term volatility in pursuit of medium to long-term returns can increase their expected real return, although this will require an ability to withstand periods of disappointing returns.

This starting point will then determine the extent to which additional risk premia (eg, duration, equities, credit etc.) or alternative real assets can be added in order to seek returns and additional diversification. Furthermore, the investor may wish to consider taking active management risk, especially strategies that have the capacity to short assets. The experience of 2022 illustrated that an inflation shock can hurt most assets and, for that year, the ability to be short assets could have diversified returns handily. 

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