Deflation and Stock and Bond Returns

Overview: With expected inflation rates very low, there will be significant attention on the possibility of deflation causing the stock market to fall. This blog examines the relationship between the rate of inflation and stock and bond returns. Generally, the research shows that stock returns are no lower in deflationary environments than in normal inflationary ones. The research does find, though, that both stocks and bonds have done poorly in high-inflation environments.

Expected inflation rates in the U.S. and elsewhere are very low. Figure 1 shows the average annual expected inflation rates in the U.S. over the next one, three, five, 10, 20 and 30 years.

Figure 1


In every case, the expected rate of inflation is less than 2 percent per year and the expected inflation rate is actually –0. percent over the next year. This is far from the norm for the U.S. and indicates that very low inflation or deflation remains possibile.

A frequent, but as we will see inaccurate, assumption is that stocks do extremely poorly during periods of deflation. The argument is that deflation causes people to delay spending because they know prices will be lower in the future, which creates a vicious spiral that harms businesses, the economy and, ultimately, stock prices. Another common, and much more accurate, belief is that bonds tend to do well during periods of deflation. Before we take a look at the data in either case, let’s distinguish between expected and unexpected rates of inflation (or deflation).

Realized inflation can be decomposed into two components:

Realized Inflation = Expected Inflation + Unexpected Inflation

In an efficient market, stock and bond prices should reflect expected inflation and only change in response to unexpected inflation. Therefore, when analyzing the relationship between asset class returns and inflation, it is best to analyze the relationship between asset class returns and unexpected inflation. In addition to using an estimate of unexpected annual inflation in my analysis, I also use real returns instead of nominal returns.

Figure 2 presents the average, maximum and minimum annual real returns over the period of 1928–2013 for the S&P 500 and five-year Treasuries during different unexpected inflation environments.

Figure 2


In the first table in Figure 2, the annual average real return on stocks and bonds is calculated during periods when unexpected inflation is well below average (“20th Percentile or Lower”), around its average (“Between Two Extremes”) and well above average (“80th Percentile or Higher”). For stocks, this table shows that stock returns are roughly similar in the low and average unexpected inflation environments but tend to be lower during high unexpected inflation environments. For bonds, real returns tend to be very high in low unexpected inflation environments and very low in high unexpected inflation environments, as expected.

The second and third tables in Figure 2, however, are worth keeping in mind. While the first table shows what happens on average, these tables show that the range of returns is wide. This simply means that while we have a good sense of what happens on average in each environment, real returns for either stocks or bonds in any given year could be high or low regardless of the unexpected inflation rate.

To put this last point in perspective, Figures 3 and 4 show scatter plot relationships between real stock returns and unexpected inflation (Figure 3) and real bond returns and unexpected inflation (Figure 4).

Figure 3


Figure 4


The primary takeaway from Figure 3 is that the relationship between real stock returns and inflation is a weak negative correlation. The general tendency is for stock returns to be higher in low unexpected inflation environments and lower in high unexpected inflation environments. This relationship, however, is not particularly strong. Said differently, as the tables in Figure 2 also show, it is entirely possible for stock returns to be high or low in any given inflationary environment.

Figure 4 shows a much stronger negative correlation relationship between bond real returns and unexpected inflation. Compared with Figure 3, the plot points in Figure 4 are more closely clustered around the trend line. By knowing the unexpected inflation rate in a particular year, you can fairly accurately guess how bonds did that same year.

Overall, these results show that stocks by no means do poorly during periods of low unexpected inflation. On average, stocks have done very well during periods of low unexpected inflation and worse in periods of high unexpected inflation. Bonds show similar tendencies but with a much stronger connection to unexpected inflation.

This commentary originally appeared January 30 on

Jared Kizer is the chief investment officer for the BAM ALLIANCE. See our disclosures page for more information. Follow him on Twitter.

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