Want to Mitigate Inflation? Take a Portfolio Approach
- Surging U.S. consumer prices have energized the debate about inflation but our July Research paper, “Assessing Inflation: Theories, Policies and Portfolios,” argues that the debate over inflation generally suffers from a lack of definition – and, therefore, comprehension.
- Currently, we believe there are fatter inflation tails than the market has expected. But longer term, there is a high probability that inflation will be contained.
- Nonetheless, for investors who wish to hedge against inflation risk, we demonstrate how a portfolio approach that combines multiple strategies may be effective in a variety of inflation scenarios.
A surge in U.S. consumer prices has energized the debate about inflation and what investors should do about it.
Inflationistas believe massive fiscal and monetary stimulus is setting off a self-sustaining cycle of rising prices. Others, including the Federal Reserve and the Biden Administration, say elevated inflation readings in recent months will prove transitory. They stem chiefly from temporary factors such as supply bottlenecks and a spike in post-pandemic consumer demand.
Our July Research paper, “Assessing Inflation: Theories, Policies and Portfolios,” argues that the debate over inflation generally suffers from a lack of definition – and, therefore, comprehension. Measures of inflation can vary widely and some, such as the consumer price index, tend to overstate inflation. Theories of inflation also have evolved, having undergone two major inflection points since the 1970s.
Currently, we believe there are fatter inflation tails than the market has expected. But longer term, there is a high probability that inflation will be contained. However, for investors who wish to hedge against inflation risk, we demonstrate how a portfolio approach that combines multiple strategies may be effective in a variety of inflation scenarios.
A Portfolio Approach For Inflation-Hedging
The potential benefits of a portfolio approach are easy to see.
Consider a simple example with three commonly used inflation-hedging assets: Treasury Inflation-Protected Securities (TIPS), commodities and real estate investment trusts (REITs).Footnote1 Figure 1 plots inflation beta versus the Sharpe ratio for optimal portfolios with different inflation beta targets, as well as the three individual assets.Footnote2, Footnote3 The results show that optimal portfolios have the potential to deliver better return and/or hedging benefits than individual asset classes.
Figure 2 details our assumptions about the characteristics of these asset classes and how they can be combined in diversified portfolios with greater estimated returns and lower volatility, on a leveraged and unleveraged basis. The two portfolios have positive inflation betas and achieve higher estimated returns and Sharpe ratios than individual asset classes, except for REITs, which have a negative inflation beta.
Macroeconomic Scenarios And Asset Tilts
Optimizing the overall portfolio also requires factoring in how individual asset classes may perform in various macroeconomic scenarios. Figure 3 shows four macro scenarios and our probability estimates for each. These reflect our current views on macroeconomic scenarios and their probabilities, as well as the allocations in the following analysis, all of which are subject to change.
Putting It All Together
The bar chart in Figure 4 shows asset tilts with respect to the market portfolio under each scenario, as well as the probability-weighted average of the four scenarios.Footnote4
As expected, inflation-hedging assets such as global inflation-linked bonds and commodities have higher expected returns in inflationary scenarios. However, a higher return does not necessarily translate to a higher optimal weight in a given scenario. What matters most is relative returns across assets under each scenario. For example, in the stagflation scenario, the portfolio tilts toward various inflation-hedging assets such as inflation-linked bonds, commodities and private natural resources.
Overall, the results show that inflation-hedging assets can play a constructive role in an overall portfolio, even when the total probability of higher-than-expected inflation is low at 40%. Furthermore, we should note that these results reflect our current views on macroeconomic scenarios, and allocations are subject to change. Please refer to the full Research paper for a complete analysis and information on methodologies and calculations.
