April 2022 / INVESTMENT INSIGHTS
Asset Allocation in the Era of High Inflation
Responding to changing growth and inflation dynamics
- Inflation is one of the biggest risks facing investors in 2022, made worse by the surge in energy and commodity prices that followed Russia’s war on Ukraine.
- In this study we looked at which asset classes can be used to hedge against inflation, based on monthly historical data from September 1976 to December 2021.
- We provide some guidelines as to how investors could tactically adjust their portfolio asset allocation in response to changing growth and inflation dynamics.
Inflation is one of the biggest risks facing investors in 2022. The risk has increased after the surge in energy and commodity prices that followed Russia’s invasion of Ukraine and the subsequent sanctions against Russia. In the U.S., consumer price inflation rose in February to 7.9%—its highest rate in 40 years—with increases in food, rent, airfares, apparel, and many other items. Inflation is also headline news in other developed countries, posing severe challenges to the ultra-accommodative monetary policies of central banks. Whether high inflation is transitory or permanent has been a hotly debated topic. What is certain is that the short-term outlook has been made worse by the spike in commodities, and inflation is likely to remain elevated relative to pre-pandemic levels for an extended period.
Regardless of its path, inflation affects everyone, particularly those with longer investment horizons. This is because inflation likely reduces our purchasing power, and over time, it can potentially result in a substantial erosion of our net worth in real terms (Fig.1). For retirees, it may also increase the risk of outliving their nest eggs. With elevated inflation in the post-pandemic recovery persisting longer than many had anticipated, it is of paramount importance to manage our portfolios well against inflation risk. It is “real growth,” or the ability to grow purchasing power over time, that matters most to investors.
Impact of Inflation on Long-Term Purchasing Power
(Fig. 1) Real value of USD 100 at end of period
Is Gold the Best Inflation Hedge?
The next question, naturally, is which asset classes can be used to hedge against inflation? The answer seems obvious: Many believe that inflation-sensitive assets such as gold and inflation-linked government bonds (e.g., U.S. TIPS1) are the best inflation hedges. But is this really the case?
Our research shows that the same asset can display very different inflation sensitivities in different inflationary environments. More specifically, we studied if, and how, major asset classes have behaved differently toward expected and unexpected inflation. The results are shown in Fig. 2. For expected inflation, we found that short-term TIPS were a good hedge, while both long-term TIPS and gold were very poor hedges. For unexpected inflation, gold exhibited a strong beta to inflation, but both long and short duration TIPS fell short.
Inflation Beta* for Expected vs. Unexpected Inflation
(Fig. 2) September 1, 1976, through December 31, 2021
Many nominal asset classes, including traditional stocks and bonds, tend to directionally compensate for expected inflation—sometimes better than inflation-sensitive assets. But these nominal assets typically suffer from drawdowns during periods when inflation surprises to the upside. Thus, investors in a typical stock/bond portfolio face a conundrum: When times are good and inflation rises predictably, their current asset mix should rise strongly but leaves them exposed to sudden drawdowns when inflation rises unpredictably.
Real Assets Equities Tend to Perform Better in an Inflationary Environment
This research has found that real assets equities responded more favorably to periods of high or rising inflation than the broad equity market, where returns are relatively weak, at the cost of less favorable returns during periods of low or falling inflation, where broad equity returns are relatively strong. On the contrary, TIPS provide a real rate of return guaranteed by the government, thus eliminating inflation risk, but responded much less strongly to inflation surprises and really only preserve capital that is dedicated to TIPS. Thus, real assets equities can achieve a similar inflation hedge with a much smaller capital allocation than inflation-linked bonds.
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