PART II of II
Executive Summary
Traditional institutional portfolios with risk characteristics similar to a 60/40 stocks/bonds allocation are not well-positioned for unexpected inflation. Our conclusion is based on the following findings:
Stocks are not effective inflation hedges, particularly in the short- and medium-term
Traditional institutional allocations resemble a "bet" on low inflation
However, while predicting future inflation is challenging, a risk-based approach to strategic asset allocation may generate more balanced performance across both inflationary and deflationary periods. We also find that:
Gold may not be the most effective inflation hedge available to investors
Tactical hedging against inflation or deflation can be accomplished more effectively with strategies that have a high beta to unexpected changes in inflation
Waiting for a period of high inflation (or inflation uncertainty) to occur may be too late to efficiently hedge against its negative effects
Our analysis examines periods of increasing and decreasing inflation but focuses on unexpected changes which lead to revaluations of asset prices. One of the main drawbacks of traditional inflation analyses is the limited number of observations, as well as the absence of data for some assets such as TIPS in stagflation. A benefit of our focus on unexpected inflation is the ability to observe multiple data points of asset performance in both inflationary and deflationary periods (160 inflation surprise periods vs. only 22 inflation regime periods).
Introduction
In Part I of this paper published in March, 2010 we outlined the major considerations surrounding the potential for an increase in future inflation. In Part II we build upon these insights by examining the strategic case for inflation protected assets in portfolio construction. Our aim in this paper is to provide both a theoretical and empirical framework to examine how inflation protected and inflation sensitive assets may perform given varying inflation levels. For simplicity, we examine the "asset side" of a portfolio, without regard to any specific liability stream which will differ dramatically by investor type. For liabilities that are nominal, liabilities will decrease in real terms due to increasing inflation while liabilities that are inflation adjusting will remain constant (and increase in nominal terms). Of course, these details should be incorporated in any customized asset allocation.
In Section I we provide a theoretical framework to consider how inflation may affect U.S. equity, U.S. Government Bonds, U.S. TIPS, Commodities and other alternative asset classes in the short-, medium- and long-term1. In Section II we analyze the historical performance of these asset classes in various economic environments both individually and in a portfolio context. Finally, in Section III we address methods for tactically hedging inflation using specific strategies.
There are a few important results that emerge from our analysis. First, equities have not been effective hedges against inflation in the short- or medium-term. Given most institutional portfolios have risk characteristics similar to a canonical 60/40 stocks/bonds benchmark, they may not be expected to perform well in inflationary periods. Second, we find that allocating capital to commodities and TIPS can improve the performance of portfolios in inflationary regimes. Third, that an equal risk-based approach across U.S. equity, U.S. Government Bonds, U.S. TIPS and Commodities may provide more balanced performance than a canonical 60/40 portfolio across both inflationary and deflationary periods. Fourth, we find that specific strategies which may be considered for their inflation hedging characteristics demonstrate varying efficacy in their ability to compensate investors for unexpected inflation. These results suggest investors do have tools available to protect against unexpected inflation if they incorporate them into their asset allocation before inflationary periods are priced in by the market.
The Impact of Inflation on Asset Prices
Unexpected inflation affects assets by altering the expected value of future cash flows. Although the performance of assets during periods of varying inflation is an important consideration in asset allocation, as discussed in Part I of this series, what we believe matters most to the future performance of asset classes is the unexpected level of realized inflation and changes in the expectations of future inflation. Simply stated, only a realization of inflation which differs from the market consensus or a change in the consensus itself will directly lead to value gained - or lost - by holding inflation sensitive or inflation protected assets. As a result, this paper will focus on identifying how assets respond to inflation surprises (inflation realizations differing from expectations) and to changes in inflation expectations.
Section I. The Theoretical Framework for the Effect of Unexpected Inflation on:
Equities, Government Bonds, TIPS, Commodities, Alternatives
Equities
Many investors traditionally think of equities as an effective hedge against inflation2. In a frictionless world rising inflation should have no effect on companies' earnings as they can fully adjust prices without lowering demand. Of course, in practice, there are market frictions and the ability of companies to pass on rising costs to customers varies. Furthermore, even if corporate earnings could fully adjust for inflation, investors' required rate of return may increase if inflation expectations rise. Inflation is generally a persistent phenomenon and unexpected inflation tends to cause market participants to expect higher inflation in the future. Therefore, unexpected changes in inflation will in practice affect corporate earnings and equity prices (to varying degrees).
Focusing on unexpected increases in inflation, company earnings may actually benefit in the short term as depreciation expense is understated (since replacement costs will be higher) and wages adjust more slowly than the prices of output goods and services (described by the infamous Phillips Curve). However, this short term effect is not necessarily a benefit to equity prices if investors are forward looking and focus on the longer term detrimental effects of higher inflation. In fact, we have seen that stock valuations tend to be compressed in the short- and medium-term in inflationary periods3,4.
Over the long term, if monetary policy is not sufficiently aggressive to moderate inflation expectations, market participants will eventually adjust and reach a new equilibrium where persistently high inflation is both expected and realized. In that state of the world, equity holders may not be fully compensated for persistently high inflation due to real economic costs of high inflation which act as a drag both on earnings and equity prices. In fact, we expect stocks to have a long term nominal return that is higher in inflationary periods, though we also expect that real returns would otherwise be higher without inflationary pressure. Long term inflationary periods create a negative pressure on corporate earnings as consumers are pushed into higher tax brackets and consume less5. Higher effective tax rates might also increase investors' required rate of return beyond the direct effect of inflation if they are to maintain a consistent after-tax real return on capital, which will affect equilibrium prices.