After having faded into the background for several years, inflation has once again become a hotly debated topic. Whether one’s expectation is for higher or lower inflation, we believe it is advisable to identify a portfolio’s sensitivity to inflation surprises and proactively manage this inflation risk. We also present a framework to help investors size inflation hedging assets relative to existing portfolio holdings.
In response to inflation risks, many investors are considering real assets such as Treasury Inflation-Protected Securities (TIPS) and commodities to address potential vulnerabilities at the portfolio level.
The benefits of holding some portion of a portfolio in real assets during inflationary periods seem clear. However, when it comes to sizing allocations, solutions are less intuitive. Fortunately for investors, there is a simple, effective framework to optimize real asset allocations, with a focus on inflation hedging and the impact rising inflation could have on a portfolio.
Real assets historically have tended to be effective as inflation hedges
A portfolio’s sensitivity to increases in inflation, known as “inflation beta,” can be quantified by studying the impact that historical changes in inflation surprises have had on returns. Figure 1 illustrates the sensitivity of a variety of asset classes to a 1% unexpected change in inflation. For example, when one-year inflation prints at 2.5%, but the expectation at the beginning of the year was for 1.5%, this represents a 1% inflation surprise.
Studying almost 50 years of data, we observe that nominal asset classes like broad equities and fixed income have had a negative response to inflation surprises, meaning that when inflation increases, asset values generally fall. Real assets, on the other hand, such as TIPS and commodities, have exhibited a positive response to inflation, underscoring their potential effectiveness in mitigating the effects of inflation.
How large an allocation to real assets do investors need?
One way to look at the allocation decision to real assets can be through the lens of inflation risk management. A typical risk management process might look like this:
- Identify a portfolio’s current inflation risk, as well as tolerable inflation risk levels
- Use inflation betas to scale into real assets and out of nominal assets over time until the tolerable level of inflation risk is reached
Inflation betas are additive. According to Figure 1, a simple weighted average of the inflation betas of a typical 60/40 portfolio (60% equities and 40% bonds) results in a combined inflation beta of approximately −2.5. In an inflationary scenario, this is clearly a risk to portfolio returns.
The question now becomes, how much of that negative beta does one want to offset and what portfolio shifts would be required? For example, if one were able to reduce inflation risk by one-third, it would already go a long way toward helping address the risk of an inflation surprise. And, as we can see in the next step, that is an entirely reasonable target.
Calculating desired allocations to real assets
To calculate desired allocations to real assets, we use three different types of real assets:
- First, TIPS, with an inflation beta of almost one
- Second, commodities collateralized with TIPS, with an inflation beta of 7.5 (see Figure 1)
- And finally, a multi-real asset allocation for which an investment manager determines the mix of several real asset classes, with an inflation beta of 2.5 (see Figure 1)
As Figure 2 illustrates, modest allocations to real assets can potentially go a long way toward mitigating inflation risk in investors’ portfolios. Note that the more the real asset allocation is tilted towards TIPS, the larger the required allocation to seek a desired improvement in inflation beta. This is because TIPS have an inflation beta of close to 1, essentially hedging the assets invested in TIPS. As a result, one would need about a 24% portfolio allocation to reduce a 60/40 portfolio’s inflation risk by one-third.
By turning to multi-real solutions that make allocations to additional real assets with larger inflation betas, such as commodities, gold, and currencies, investors could seek to achieve the hedge target with a portfolio allocation of approximately 16%. Given the higher return estimates of multi-real portfolios relative to plain TIPS, this represents a compelling implementation option, in our view.
And finally, one of the most capital-efficient inflation hedges available involves allocations to commodities, especially when collateralized with TIPS. Such an allocation has an inflation beta of more than 7, and small allocations may materially improve the inflation beta of the overall portfolio. An approximately 8% allocation to a commodities strategy may reduce inflation beta, or risk, by one-third based on historical data. We do note that allocations to commodities or multi-real asset strategies may also increase portfolio volatility or other risks; a prudent, active management approach can help manage these risks.
Inflation risk can (and should) be managed
Investors concerned about mounting inflation can prepare ahead of time and help prepare portfolios with allocations to real assets that are expected to have a positive response when inflation surprises to the upside. If investors are thoughtful about which inflation solutions to choose, even modest adjustments to the overall portfolio allocation can potentially lead to a meaningful reduction in investors’ exposure to inflation.
Inflation beta represents sensitivity of asset class excess returns (over the “risk-free” rate) to inflation surprises in two-factor GDP growth and inflation surprise (realized inflation minus Philadelphia Fed Survey inflation forecast) model (i.e., when inflation surprises by +1%, an asset with an inflation beta of 1.5 is expected to have an excess return of 1.5%, all else equal); based on quarterly rolling annual data from 1973 to 2020 and since 1997 for TIPS. U.S. equities: S&P 500 Index; U.S. core fixed income: Bloomberg Barclays U.S. Aggregate Index; Commodities: Bloomberg Commodity TR Index; TIPS: Bloomberg Barclays U.S. TIPS Index; TIPS + Commodities: equally weighted allocation to the prior identified indexes; Diversified real asset portfolio: PIMCO Inflation Response Index (45% Bloomberg Barclays U.S. TIPS Index, 20% Bloomberg Commodity Index Total Return, 15% JPMorgan Emerging Local Markets Index Plus (Unhedged), 10% Dow Jones U.S. Select REIT Total Return Index, 10% Bloomberg Gold Subindex Total Return Index).