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Global Investment Strategy

March 23, 2015 (Weekly Update)

Tracie McMillion, CFA®, Head of Global Asset Allocation Strategy

Weekly market insights from the Global Investment Strategy team

  • Currently, inflation is trending near zero due to the recent, significant decline in oil prices.
  • "Real" after-inflation returns of U.S. stocks and bonds have been the highest in periods in which inflation has averaged between two percent and three percent.

What it may mean for investors

  • The "real" after-inflation return measures the purchasing power gained by investors.

There's Return and Then There's "Real" Return

Can we simply compare an individual portfolio's return from one year to the next to get an accurate measure of its overall performance? Let's say in one year a portfolio returned eight percent, and during the following year, it returned a mere five percent. The investor did not make any significant changes to its mix of assets, hence the risk level of this portfolio did not change from year to year. Instead, in this example, the higher return during the first year was solely due to higher market prices. Now ask yourself, in which of these two years was the investor better off? At first glance, the first year seems to be the obvious choice, right? But, if we dig a little deeper, perhaps it’s not. Turns out, there is another important question we need to answer to determine which portfolio performed better, namely: "What was the rate of inflation in each of the two years?"

When the latest Consumer Price Index (CPI) is released tomorrow, it is expected to show that prices in the U.S. were virtually flat over the past 12 months. In other words, in the last year, on the whole, the U.S. economy has experienced little-to-no change in consumer prices. Certainly any consumer can tell you that the prices of some goods and services rose during this time period while others dropped. The CPI measures the overall trend in price levels. We believe tomorrow's CPI figure may even indicate that inflation in the U.S. has eased slightly over last year, mainly owing to the drop in oil prices. Moreover, when we consider the so-called "core inflation" (a measure of inflation that excludes energy and food), estimates point to the annualized increase in prices to be somewhat muted, likely increasing a modest 1.7 percent over the past year.1

Historically, such a low rate of inflation is not the norm. Over the past 25 years, global inflation has averaged 10.4 percent but generally has been much lower in the U.S.2 Over the past 100 years U.S. inflation has averaged just over three percent. More recently, U.S. inflation reached a high of 13.6 in 1980, yet over the past 10 to 15 years it has averaged close to the Federal Reserve's target level of 2.0 percent.3 In a low-inflationary environment, asset returns, on the surface, could also appear to be lower. However, an asset’s real return (return minus the rate of inflation) may be the same, or even higher than that experienced in a high inflationary period. Why is it important for investors to consider the real return for an asset? Because the real return tends to set a higher bar for measuring positive returns of an asset. The return on an individual investment is positive in real terms if it exceeds the rate of inflation. Real returns, in turn, allow the investor to purchase more goods with the assets in the portfolio at the end of a given period.

Average Real Return When Inflation is…
 Average Real Return When Inflation is…
Source: Morningstar Encorr, 03/20/2015. Yearly series, data is from 1926-2014.
Note: Inflation = Yearly CPI as calculated by the Bureau of Labor Statistics.

Returning to our example above, a return of five percent is equally attractive if the inflation rate is near zero (approximately where the U.S. rate of inflation stands today) compared to an eight percent return when the inflation rate is closer to its longer-term average of three percent. In our example, if we account for the level of inflation and assume inflation in the first year was three percent and in the second year it was flat, our eight-percent “nominal” return in year one is equivalent to a five-percent real return (8% - 3% = 5%), and our five percent “nominal” return in year two matches the five percent real return (5% - 0% = 5%). In other words, you should be able to purchase the same amount of goods with both of these returns.

We assume that over time, investors will command a fairly constant risk premium over the inflation rate to invest in risky assets (stocks, bonds, real estate etc.), but each year we review this assumption based on actual market activity. What we have found is that, on average, bonds typically have real returns of about two percent to three percent, while equities tend to have real returns in the neighborhood of seven percent or nine percent. We will release our forward-looking return assumptions for several asset classes later this summer, including an inflation component and a "real return" component among them.

1 Bloomberg Consensus Estimates, as of 3/20/15.
2 International Monetary Fund, World Economic Outlook Database, October 2014.
3 Bureau of Labor Statistics, Consumer Price Index - All Urban Consumers, 12-Month Percent Change, 12/31/1914 - 12/31/2014.

Tracie McMillionAbout Tracie McMillion

Tracie McMillion is the head of global asset allocation strategy for Wells Fargo Investment Institute (WFII), an organization that provides global manager research and investment strategy advice to Wells Fargo’s Wealth, Brokerage, and Retirement (WBR) division. WBR is comprised of Wells Fargo Private Bank, Wells Fargo Advisors, Wells Fargo Institutional Retirement, and Abbot Downing businesses, accounting for more than $1.6 trillion* in assets under administration.

In her current role, Ms. McMillion leads the development of global investment strategy. She oversees the creation of asset allocation recommendations and writes economic and market commentary and analysis. Ms. McMillion has been quoted in The Wall Street Journal and Barrons, on CNBC, and in other financial media outlets.

Ms. McMillion has more than 18 years of experience in financial services. Prior to her current role, she served as an asset allocation strategist and a senior investment research analyst for Wells Fargo and predecessor firms. Earlier in her career, she served as lead portfolio manager for Evergreen Private Asset Management where she managed assets for high-net-worth clients and philanthropic organizations.

Tracie earned a Bachelor of Arts in Economics and a Master of Business Administration from the College of William and Mary in Virginia. She is a CFA® charterholder and member of the CFA North Carolina Society. Ms. McMillion is located in Winston-Salem, North Carolina.

*As of Sept. 30, 2014

Risk Factors

All investing involves some degree of risk, whether it is associated with market volatility, purchasing power or a specific security. Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments.

An index is unmanaged and not available for direct investment.

The S&P 500 Index is a capitalization-weighted index calculated on a total-return basis with dividends reinvested. The index includes 500 widely held U.S. market industrial, utility, transportation and financial companies.

The Ibbotson Associates Stocks, Bonds, Bills and Inflation U.S. Intermediate-Term Government Bond Index (noted as "IA SBBI US IT Govt Bond TR" on the chart on page 2) is an unweighted index which measures the performance of five-year maturity U.S. Treasury Bonds. Each year a one-bond portfolio containing the shortest non-callable bond having a maturity of not less than five years is constructed. Bonds with impaired negotiability or special redemption privileges are omitted, as are partially or fully tax-exempt bonds starting in 1943. To measure holding period returns for the one-bond portfolio, the bond is priced (with accrued coupons) over the holding period and total returns are calculated.


Global Investment Strategy is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company and provides investment advice to Wells Fargo Bank, N.A., Wells Fargo Advisors and other Wells Fargo affiliates. Wells Fargo Bank, N.A. is a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by the Global Investment Strategy division of WFII. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

The report is not intended to be a client specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.

Brokerage products and services are offered through Wells Fargo Advisors. Wells Fargo Advisors is the trade name use by two separate registered broker-dealers: Wells Fargo Advisors, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, non-bank affiliates of Wells Fargo & Company.