Higher inflation equals lower real returns on all assets

Balancing interest rates and bonds IMAP Ashley Owen

"How will asset classes and investment portfolios perform in a new world of higher inflation? The evidence is clear!....Higher inflation in future will mean not only lower nominal (headline) returns on asset classes and portfolios, but also lower real (inflation-adjusted) returns.

This will be a big change from the past 30 years of low inflation and unusually high nominal and real returns from all types of assets", says Ashley Owen

This chart shows real (after inflation) total returns (ie price gains plus income) from eight major asset classes since 1900. This period is long enough to cover all sorts of inflationary conditions, from very high inflation, through to deep deflation, depressions, world wars, and everything in between.

The asset classes are:

  • Australian shares
  • US shares (in AUD terms)
  • Australian housing (capital city median prices)
  • Australian 10 year government bonds (NSW bonds before 1930)
  • US 10 year Treasury bonds
  • Australian cash
  • precious metals (we use an equal-weighted basket of gold, silver, and platinum, because holding gold was illegal for much of the period)
  • Australian listed property (since 1974)

Please note: Returns are in Australian dollars after Australian inflation – ie ‘real’ returns for Australian investors (before fees & taxes).

By  Ashley Owen, CFA

Ashley Owen, CFA  Founder & Principal of Owen Analytics

Overall returns

There are four sets of returns on the chart. At far left are average annual real total returns from the asset classes over the whole period, ranked from highest returning asset class to lowest. At the top of the tree, Australian and US share markets both generated average annual real total returns of 6.5% pa over the whole period.

Next were listed property trusts (since 1974), then Australian housing. Shares and property have displayed decent amounts of inflation protection, with returns well above inflation over the whole period.

Further down the tree, Australian and US bonds, and precious metals, all posted modest returns above inflation over the whole period. Cash is at the bottom, barely above inflation.

‘Real returns’ – where do they come from?

Growth in company profits and dividends (as well as property rents and values) ultimately comes from growth in overall economic activity. ‘Real’ (inflation-adjusted) economic growth rates in Australia, US, and other ‘developed’ markets, have remained more or less constant over time, after they became mature, high income (‘developed’) countries.

For example, real GDP growth has averaged around 3% pa in Australia and the US over the past century, with only temporary deviations for deep recessions.

Because real economic growth rates have been more or less consistent, regardless of inflation, many investors assume that this should mean that ‘real’ returns from companies on the whole (the broad share market) should also remain more or less consistent, regardless of inflation.

Unfortunately this is not the case. Investment returns are very much dependent on the inflationary environment.

Returns differ in different inflationary environments

Throughout history, not only have the ‘nominal’ (headline) returns from all of the main asset classes been lower in periods of higher inflation, but ‘real’ (after inflation) returns from all asset classes have also been lower than average in periods of high inflation, and higher than average in periods of low inflation.

This is the most striking feature of the chart - the other three sets of returns on the chart. These are the average real returns in years when inflation was ‘low’, ‘moderate’ or ‘high’.

Since 1900, Australian CPI inflation has averaged 3.8% per year, but inflation has ranged widely from a high of 19% in 1951 (Korean war inflation spike), down to negative -12% (price deflation) in 1921 (post-WW1 slump).

For this chart we have divided all years since 1900 into three categories:

  • ‘Low inflation’ years – the bottom one third of years, when inflation was below 2%.
  • ‘Moderate inflation’ years – the middle one third of years, when inflation was between 2% and 5%
  • ‘High inflation’ years – the top one third of years, when inflation was above 5%

No effective inflation hedge

A second observation is that no asset class has delivered an effective ‘inflation hedge’ that performed better when inflation was higher, not even precious metals. In high inflation years, precious metals did beat bond and cash, but real returns were still negative on average – hardly an ‘inflation hedge’.

The best real returns were broad share markets, albeit with significantly lower real returns when inflation was high.

Ranking remains similar in all inflationary conditions

A third observation is that the ranking of returns between different asset classes has been quite similar in all types of inflationary conditions.

Shares and property have done better than bonds and cash in all inflationary conditions, while precious metals are always near the bottom of the table, with relatively low real returns.

We can see that share markets have provided the highest real returns in all inflationary conditions, including providing the best inflation hedge in high inflation conditions.

The Australian and US share markets each returned a very healthy 6.5% above inflation over the whole period, but returns were different in different inflation environments.

When inflation was low, Australian and US shares returned double the overall average returns, but when inflation was high, the returns were much lower than average – virtually zero for Australia, and less than 3% pa for US shares (in Australian dollar terms).

Why is this important?

It especially important in portfolio construction now, because we have just enjoyed three decades of nirvana, with unusually low inflation, which produced unusually high nominal and real returns from the main asset classes – shares, bonds and property.

As portfolio managers and asset allocators, we looked good because just about every asset class did well! Mostly it was not skill, but pure luck - being in the right place (in just about any asset class), at the right time (the post-1980s era of declining/low inflation and interest rates).

All we really had to do was steer clear of frauds, fads, and bubbles, which fortunately are relatively easy to identify and avoid.

Now the world has changed. That wonderful era of declining/low interest rates, declining/low inflation, and unusually high nominal and real returns is over. Whether we are heading into an era of ‘high inflation’ or merely ‘moderate inflation’, in either case we can expect nominal and real returns from all types of assets to be significantly lower than the past three decades.

In the new world, the next generation of portfolio managers and asset allocators will find it much more difficult to generate decent real returns without the lucky tailwinds of declining/low interest rates and inflation.

Time for real skill to shine!

See also these related articles:

The BIG picture – portfolios perform for the passive & patient

This time is different’ – or is it? 123 reasons NOT to invest!


This article is written by Ashley Owen, CFA and the views expressed are his own.

Ashley is a well known Australias market commentator with over 40 years experience.

Membership & associations:
• CFA charter holder
• Signatory to the UN Principles for Responsible Investment
• Occasional member, Education Advisory Board Working Committee of the CFA Institute (US)

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