Stocks are a bad short-run inflation hedge and the best long-run one

Fama and Schwert documented the awkward result: over short horizons, common stock returns are negatively related to both expected and unexpected inflation. Equities are claims on real assets, so the theory says they should keep up — but in the data, inflation surprises are bad for stocks in the year they arrive. Rising inflation raises discount ratesDiscount rateThe rate at which future cash is converted to a value today. A higher discount rate lowers the present value of the same future earnings, which is how rising rates cut share prices without anything changing at the company. and usually arrives alongside slowing growth and tightening policy, and those effects dominate.

Over long horizons the relationship inverts, because earnings and dividends are nominal quantities that rise with the price level. The bundled history on this site shows it plainly: across the full record, US equities compounded a large real gain despite passing through the 1940s and the 1970s. The 1970s are the honest counter-example — real equity returns over 1966 to 1982 were negative even though nominal returnsNominal returnReturn before adjusting for inflation — the headline number. Useful for comparing against a stated interest rate, misleading for comparing across decades. were roughly flat, and it took sixteen years to resolve.

Bonds are the clearer casualty. A nominal bondNominal bondA bond promising fixed cash amounts, with no inflation adjustment. Unexpected inflation transfers wealth from its holder to the borrower directly, which is why bonds are the clearest casualty of an inflation surprise. promises fixed cash flows, so unexpected inflation transfers wealth from the lender to the borrower directly, and duration determines how much. 2022 was the demonstration: inflation surprised upward, long duration repriced, and stocks and bonds fell together — the failure mode a 60/40 portfolio is not supposed to have, and one that follows straightforwardly from both being priced off the same discount rate.

The instruments that hedge inflation directly are the ones indexed to it. TIPSTIPSTreasury Inflation-Protected Securities: US government bonds whose principal rises with CPI. They pay a lower headline yield than ordinary Treasuries because the inflation protection is the compensation. pay a real coupon on a principal that tracks CPICPIThe Consumer Price Index, the standard US measure of inflation. It tracks a fixed basket of goods, which is why your own inflation rate can differ from it substantially and persistently., and Series I savings bonds do something similar for small amounts with a purchase limit. Neither is a growth asset; both are the right tool if the specific risk you are hedging is a fixed nominal liability meeting an unexpected price level.

The planning version: hold equities for the multi-decade real returnReal returnReturn after inflation has been removed: what your money can actually buy afterwards, not what the number on the statement says. A 7% return in a 3% inflation year is a real return of about 3.9%., do not expect them to protect you in the year inflation arrives, and if you have near-term real spending to defend — the first years of retirement, most obviously — defend it with something actually indexed rather than with an asset that gets there eventually.