There is a lot of debate regarding whether we are heading into deflation or inflation. How do investment strategies differ depending on whether we are in an inflationary or deflationary environment?

Types of economic environment

  • Deflation, high growth
  • Deflation, low growth
  • Low inflation
  • Inflation, high growth
  • Inflation, low growth

It is possible to have deflation and high growth due to technological advances, however people are more familiar with deflation associated with low growth. That is what central bankers are most terrified by, and want to avoid at any cost. A low inflation environment is seen as stability. High inflation can be associated with high growth, for example when the demand for goods is increasing and suppliers are struggling to keep up with the demand. In such an environment, businesses are doing well and the economy is running hot. Finally we come to a high inflation low growth environment. In this case it is more of a supply-side issue where the supply of goods has decreased. Businesses are not doing well and unemployment is high.

The history of inflation and deflation in USA

History of inflation and deflation in USA (Source: Incrementum)

The above chart shows the historical consumer price index (CPI) in USA. Before 1905, there were wild swings between deflation in inflation and these were high magnitude swings. Since the introduction of the federal reserve in 1913 the swings became much less pronounced and deflation occurred less often. Since the end of the gold standard in 1971 we have been in a purely inflationary environment. Inflation started off quite high in the 1970s and has become lower over time. Didn’t we have deflation in 2008? Although some charts show that the CPI dropped to -0.5%, it does depend on how you measure inflation. If we use the official government CPI then we had very mild level of deflation in 2008.

Shadow stats vs official CPI 1980 to 2020

However, if we use the shadow stats figures shown in blue in the above chart, then we didn’t actually have any deflation. Instead we had disinflation, shown by the drop in the blue line. That begs the question, is true deflation possible in an era when the world’s reserve currency is fiat?

Real vs nominal asset returns

When looking at asset returns in these environments we do need to take the inflation rate into account. Nominal returns can be misleading when inflation is high. For example a stock price rising by 10% when the inflation rate is 12% means that the stock actually lost 2% in real terms. That is something that is not well understood by the general population. The real return is far more important than the nominal return.

Inflation beta

Inflation beta is how much an assets return increases when inflation goes up by 1%. It therefore reflects the inflation hedging property of an asset.

Inflation beta and volatility of various assets classes (Source: Vanguard)

The blue bars in the above chart show that gold and commodities have the best beta to inflation, but note that they do tend to be very volatile. Bonds have a lower inflation beta, but are also less volatile. Equities have a negative beta and are volatile (not a good combination).

Asset returns and the consumer price index (CPI)

Let’s look at real assets returns during different economic environments.

Asset returns when CPI is above or below median CPI (Source: Validea)

The above charts shows the results of a study that analysed asset returns between 1970 and 2015. The data were split into inflation below versus above the median CPI. When inflation was low (shown in blue), real estate and stocks performed the best. Cash and especially commodities did poorly. When inflation was above median CPI (shown in orange), commodities did by far the best followed by real estate and then equities. Cash did poorly. Note that this study did not include gold.

Assets returns with directional changes in CPI (Source: Incrementum)

The above charts shows the results of a study that analysed asset returns when inflation was falling, stable, or rising. When inflation was falling, commodities do terribly, and equities ruled. When inflation was stable, then all assets performed reasonably well. When inflation was rising, equities and real estate did badly, while gold and commodities performed the best. Interestingly, the metals outperformed the mining equities. These results are different from the previous study because of the different parameters used to define the economic environment.

Asset returns with different magnitudes of CPI

An alternative is to assess asset returns based on the magnitude of CPI. The above chart shows that when inflation is below 1%, commodities are a terrible investment and equities provide the best returns. When inflation is 1-5%, all assets do pretty well. When CPI exceeds 5%, commodities are the best investment and bonds have the worst returns.

Summary of assets returns in mild to moderate inflation

When inflation is rising, or over 5%, gold and commodities provide the best returns. In an environment where inflation is falling, or below 1%, real estate and equities give the best returns. Having said that, all the studies discussed here looked at inflation that was within a relatively narrow band between 0 and 13%. What happens at extreme levels?

None of the studies discussed included significant deflation because we have not had any episodes of significant deflation in the fiat era. We can look at data from the 1930s episode of deflation, but note that at that time the gold standard was in place and the price of gold was fixed. It is therefore difficult to draw any conclusions about gold from that time.

Asset returns in significant deflation

Asset real returns in deflation (Source: Ganardinerointernet)

The table above shows that in the 1930s the average inflation for the whole decade was -2.1% (i.e deflation) and during that decade bonds gave the best return and stocks and commodities did badly. In summary, when there is significant deflation (a negative rate of inflation) bonds are the best place to be. The jury is out regarding gold.

Asset returns in significant inflation

Inflation rate in Argentina

A recent example of high inflation is in Argentina. The chart above shows the volatility in the rate of inflation in Argentina, with steep rises in inflation followed by bouts of disinflation. In 2019 inflation was as high as 58%.

Merval Argentina stock index

What happened to equities during the inflationary period? The above chart indicates that Argentine stocks performed very well in nominal terms, although volatility has increased recently.

Gold priced in Argentine Pesos

Gold priced in Argentine Pesos has also performed extremely well. However, the stock and gold prices are all expressed in nominal values. How did they perform in real terms?

When values are indexed to 100 in 2011, values are as follows:
Consumer price index = 556
Stock index = 1,100
Gold = 1,972

Both stocks and gold outpaced inflation, but interestingly gold outperformed equities by almost a factor of two.

Asset returns in hyperinflation

Let’s go to the more extreme example of hyperinflation in Venezuela.

Inflation and asset returns in Venezuela

The Venezuelan stock market chart looks great, with a vertical rise up. However in real terms, stocks have not kept up with inflation. Meanwhile, gold has provided real returns that have significantly outpaced inflation.

In summary, when inflation is very high (above 20%), gold, commodities, and equities will provide the best returns (in that order). During hyperinflation, equities don’t perform so well in real terms. Gold and commodities are the winnders during hyperinflation.


When considering how you allocate your investment portfolio, it is really important to consider the economic environment. Over the past 40 years we have experienced a relatively stable environment, without any large amounts of inflation or deflation. Equities and real estate have therefore performed very well. Will that environment continue and if not which direction do you think we’re headed?