Therefore, persistently high inflation tends to have a negative effect on stocks as both corporate earnings and the multiples investors are willing to pay for earnings are compressed. This is not to suggest that nominal stock prices will decline in inflationary periods but rather that they will not necessarily adjust enough to keep real prices constant. The long term negative effect of high inflation on real stock prices will be moderated to the extent that monetary authorities are effective in tightening monetary policy and reducing inflation expectations.

Government Bonds
Unexpected inflation typically leads to an increase in nominal yields as investors revise upward their expectations for future inflation. If investors had been anticipating low and steady inflation, an inflation shock may lead investors to expect more uncertainty about the future rate of inflation. This will raise the risk premium investors require to hold nominal bonds, putting upward pressure on yields (and increasing the cost of inflation protection). Moreover, unexpected inflation will put upward pressure on bond yields if monetary authorities act to raise effective real interest rates.
As described in Part I of this paper, the following factors are the primary components which may determine the yield of government bonds above the risk-free rate (excess yield)6:
1. "Real" Term Premium - compensation for the risk associated with holding a longer-term bond and taking the risk of real rates moving
2. Inflation Expectation - compensation for expected future changes in inflation (inflation term structure)
3. Inflation Risk Premium - compensation for assuming the risk of changing inflation (inflation uncertainty)
Therefore, since [Nominal Yield = Risk Free Rate + Real Term Premium + Expected Inflation + Inflation Risk Premium], an increase in expected inflation or inflation uncertainty will put upward pressure on nominal yields (decreasing prices).

Treasury Inflation Protected Securities (TIPS)
Treasury Inflation Protected Securities (TIPS) are U.S. government bonds whose principal and coupons are adjusted for inflation. In the U.S., the value of TIPS will increase based on changes in the Consumer Price Index (CPI). Assuming no risk of the U.S. government defaulting, TIPS provide full compensation for changes in CPI. Therefore, TIPS are the "real" risk free asset to investors who hold them to maturity and seek protection from unexpected increases in the CPI. However, TIPS' daily market values are sensitive to changes in real interest rates and the risk premium associated with future real rates. Therefore, if not held to maturity (and for a portfolio which is marked-to-market) TIPS' performance may not fully hedge the effects of inflation. Because the primary tool for the Fed to combat inflation is increasing real rates, TIPS' mark-to-market value may be negatively affected during inflationary periods, offsetting some, or all, of their inflation hedging characteristics7.

Commodities are considered effective inflation hedges for at least two reasons. First, commodity prices are relatively flexible (as demand is relatively inelastic) and tend to quickly adjust to changes in the general price level. Second, commodities can actually be a direct cause of inflation and be accelerating faster than the general rate of inflation. This was the case in the 1970's as commodity price moves contributed to a global stagflation (increasing inflation during a recessionary period). Under these conditions, central banks are less likely to tighten monetary policy because they will further exacerbate recessionary pressures. In this scenario, commodity price increases are more likely to remain unchecked and can accelerate at rates far above the general rate of market price changes. Therefore, if inflationary pressures are actually led by commodities, they are likely to serve as an especially effective inflation hedge.

It is important to note that commodities are not expected to serve as an efficient hedge in all inflationary environments. For example, in a stagflation driven by decreasing demand and loose monetary policy, like the fiscally driven inflation many investors currently fear, commodity prices may trail inflation as weak demand causes their prices to fall in real terms.

Alternative Allocations
There is a multitude of alternative asset classes that have varying degrees of potential inflation hedging characteristics from timber and infrastructure projects to other private investments and hedge funds. It is intuitive that the better the ability to adjust the price of the underlying asset (with low impact on volume demanded) or its cash flows, the better the inflation hedging characteristics will be. For example, the inflation hedging efficacy of utilities largely depends on the projects' pricing power - the more constrained profits are by a regulatory framework, the lower their ability to track unexpected increases in inflation. Real estate's inflation hedging characteristics may be dependent on the flexibility to adjust rents since operating costs are partially fixed (shorter-dated leases may adjust more quickly to inflation than longer-dated contracts).

Private investments and hedge funds may also exhibit potential inflation hedging characteristics as they are able to dynamically control their investment processes in response to changes in market conditions and unexpected inflation, though the degree of their efficacy is highly specific to each investment strategy. While it may be possible to analyze the inflation hedging characteristics of specific hedge fund sub-styles (for example, Managed Futures, Fixed Income Arbitrage, etc), that is beyond the scope of this paper8.

Because the alternative investment category (private equity, infrastructure, real estate, hedge funds, etc.) is heterogeneous and not a definable asset class it is not possible to create a theoretical construct for how alternatives in aggregate should singularly respond to inflation; rather each individual strategy requires investors to perform an in-depth analysis to develop the framework on a case-by-case basis. We touch on a few specific alternative strategies in Section III.

Section II. Effect of Inflation on Strategic Asset Allocation
Empirical Evidence on: U.S. Equity, U.S. Government Bonds, TIPS, Commodities
We have discussed the theoretical framework for how Equity, Government Bonds, TIPS and Commodities9 may perform during periods of unexpected changes in inflation. We now turn to examine the historical performance of each of the aforementioned asset classes during various inflationary periods in the U.S. and in response to unexpected changes in inflation. As we have pointed out, only unexpected inflation or changes in inflation expectations can be the source of value gained - or lost - due to inflation. To add further precision to the analysis we examine combinations of inflation and growth, since inflation during periods of growth or recession are very different economic environments with varying effects on assets. For example, inflation can occur in periods of an over-heating economy or in a stagnating economy. We exclude the general Alternatives category since this is not a homogenous asset class with a single identifiable return stream.

We use three metrics for the impact of inflation on asset prices: 1) performance as a result of unexpected inflation (inflation surprise); 2) performance in increasing and decreasing inflation regimes; and 3) correlation of asset returns with future inflation (proxy for changes in inflation expectations). We measure performance as the risk-adjusted returns excess of cash (Sharpe Ratio) since this offers a direct comparison across assets and time horizons, regardless of each individual asset's volatility, variation in volatility over time and fluctuating cash rates. Focusing on returns, regardless of risk (as proxied by volatility) and changing cash rates obscures the relative effect of inflation on individual assets as well as the absolute effect on risky assets in aggregate.

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