Inflation in the U.S. has accelerated from
near zero in 2015 to 2.5% in 2018 (according to the Consumer Price Index or
CPI), propelled by trade tensions, strong consumer spending, the tight labor
market, and a boost in growth from tax reform and other fiscal stimulus. After
so many years of low inflation, the rise in 2018 points to the possibility of
Such a surprise could be damaging because many investors may be too reliant on
diversification achieved by investing in a portfolio of stocks and bonds,
which is predicated on the historical negative correlation between the two
asset classes. However, this diversification may not work as well going
forward because correlation between stocks and bonds tends to rise when
inflation is elevated. Therefore, we suggest investors consider real assets
(inflation fighters) to make portfolio diversification more robust and hedge
against the risk of higher inflation.
Will stocks and bonds deliver the same diversification at higher inflation
The correlation between U.S. stocks and bonds has been low or negative when
inflation has been low to moderate. Over the past couple of decades of low
inflation, portfolios that were diversified across nominal bonds and stocks
therefore tended to fare well on a risk-adjusted basis. It is this positive
experience that is shaping most investors’ approach to inflation today.
However, this might not be the best way to address inflation risk going
forward: Stock-bond correlations tend to increase when inflation is either
high or rising, as shown in Figure 1. This could be a big problem for
investors worried about inflation because positive correlations essentially
mean less effective portfolio diversification.
We believe inflation in the near future will be higher than in the recent
past. U.S. CPI inflation has been above 2% for 12 consecutive months, and core
personal consumption expenditures (PCE) is at the threshold of the Federal
Reserve’s target of 2%. Since inflation is a lagging economic indicator,
one may reasonably expect inflation to remain elevated in the next few
quarters, reflecting the current acceleration in U.S. economic growth.
Cyclical Outlook forecasts U.S. inflation in the 1.5%–2.0% range in 2019. Furthermore, the possibility for
inflation surprises has increased as the Federal Reserve, along with other
major central banks, appears more comfortable with inflation running at or
above the target, meaning that central banks are less likely to hit the brakes
on growth even if inflation overshoots for some time.
Protecting portfolios from higher inflation and uncertain stock-bond
PIMCO’s midyear asset allocation outlook, “Late-Cycle Investing,” notes that inflation is one of the four key investment themes at
this stage of the business cycle.
Yet, most investment portfolios may not be protected against inflation
(defined as the difference between realized inflation and inflation
expectations from a year ago).
As Figure 2 shows, stocks, bonds and the traditional 60/40 stock/bond
portfolio all have negative inflation betas such that when inflation surprises
by 1%, the traditional 60/40 portfolio would lose 1.1%. Over the last several
years, inflation has been surprising on the downside, and equities have been
positively correlated with inflation surprises. Figure 2 shows how this recent
trend hasn’t been the case over the long term. It is noteworthy that
inflation surprises are not rare; in fact, we estimate that the probability
for an upside inflation surprise today significantly exceeds the probability
for a downside surprise, given recent new tariffs, continued trade tensions,
late-cycle fiscal stimulus and robust consumer spending.
In today’s environment of elevated inflation, with risks skewed to the
upside, we think investors should consider an allocation to the real assets
shown on the right side of Figure 2: TIPS (U.S. Treasury Inflation-Protected
Securities) or other sovereign inflation-linked bonds (ILBs), commodities,
REITs (real estate investment trusts) and multi-real asset portfolios that
have the potential to perform better during times of rising inflation. Figure
3 and the following sections delve further into these four potential
TIPS/Inflation-linked bonds (ILBs)
These fixed income assets are generally expected to perform well when growth
slows, and they are the only assets where inflation protection is
contractually guaranteed: Their principal rises in line with inflation. We
think two TIPS/ILB solutions merit special attention:
Levered TIPS/ILBs: One drawback of TIPS/ILBs, typical of
the highest-quality or “safe-haven” assets, is that returns are
typically moderate. However, they are attractive assets to lever (due to low
financing costs and collateral haircuts, on par with U.S. Treasury bonds); a
levered approach can magnify return potential, while increasing inflation
hedging. Further, an allocation to levered shorter-duration TIPS has the
potential to achieve these with only modest volatility or increased risk.
Note that investing in the front end of the TIPS yield curve does not reduce
the inflation-hedging because that comes from any adjustments in the
principal, no matter the maturity; the inflation-hedging properties of five-
and 10-year TIPS are the same.
TIPS/ILB overlays: An overlay of TIPS, ILBs or CPI swaps
(instruments that transfer inflation risk from one party to another through
an exchange of cash flows) can boost inflation protection, and using
existing high quality, liquid portfolio assets as collateral means that only
limited new cash/assets are required to fund the strategy. We find this to
be a capital-efficient way to hedge inflation risk without having to choose
between return potential and inflation protection.
Commodities typically perform well in the late stages of an economic
expansion. They are highly sensitive to changes in inflation, and in some
cases, they are the source of inflation surprises. For example, food and
energy prices represent 23% of the headline U.S. CPI basket but drive 88% of
CPI volatility (as of 30 June 2018). Not surprisingly, commodities have an
inflation beta of more than five. Additionally, we believe that commodities
will perform well in the near term as the sector has historically peaked only
after an expansion ends.
Sizing of commodity exposure is important since the asset class typically has
high volatility. There are many types of commodities strategies; we seek those
that deliver high
roll yield and continuously evolve to provide the potential for diversified sources of
risk premia (alpha) and better beta. Similar to TIPS, commodities are an
excellent asset class to consider for overlays and increased capital
Real estate investment trusts derive the majority of their revenues from
rental income and distribute 90% of their taxable net income as dividends
(according to the IRS). Over the short term, REIT prices are correlated to
equities and have low inflation beta. Over the long term, however, REITs can
be an effective liquid proxy for physical real estate and tend to track
inflation more closely; real estate rents and values tend to increase with
inflation, which eventually passes through to REIT dividends and valuations.
Furthermore, REITs have a low correlation to TIPS and to commodities (0.24 to
both, as measured by correlation of monthly index returns for REITs, TIPS and
commodities 1 from March 1997 to June
2018), making them a potentially attractive addition to a balanced portfolio
of real assets.
Multi-real asset solutions
A thoughtfully diversified mix of real assets can be a
“one-stop-shop” solution for investors seeking a dynamic,
responsive inflation-hedging allocation. The potential benefits of this
approach are reduced volatility, higher return potential and meaningful
positive inflation beta if the allocations perform as expected.
By investing in a mix of TIPS/ILBs, commodities, REITs, currencies and gold,
investors can potentially increase diversification and benefit from multiple
sources of alpha, derived by actively managing within each
inflation-fighting asset class and making tactical moves across asset
Key takeaways: seek to reduce inflation risk without sacrificing return
Milton Friedman once said, “Inflation is the one form of taxation that
can be imposed without legislation.”
We at PIMCO spend countless hours studying and forecasting inflation and
designing solutions that aim to protect investment returns from inflation
“taxation.” We view inflation not only as a challenge, but also as
an opportunity to generate strong absolute returns and alpha.
If inflation surprises to the upside in the years ahead, stock-bond
correlations may increase, which would likely upset the inflation hedge that
today’s dominant portfolio construction frameworks have derived from
diversification in recent years. Drawing on the breadth and depth of
PIMCO’s investment expertise, we have pinpointed four forward-looking
inflation solutions that invest in real assets. Investing in single real asset
classes, such as TIPS, commodities and REITS, or a multi-real asset solution,
could provide a measure of protection for investors by hedging against
inflation surprises, while also enhancing diversification and boosting return
Please visit our
for more of PIMCO’s views on the complex drivers of inflation
1 REITs represented by DJ U.S. Select REIT Index; TIPS represented by Bloomberg Barclays U.S. TIPS Index; commodities represented by Bloomberg Commodity TR Index. Source: PIMCO, Bloomberg.