Executive Summary

  • As inflation spiked in the second quarter of 2021, debate about its transitory or permanent nature became more heated. Yet, as is sometimes the case with broad controversies, a lack of definition goes with a lack of comprehension.
  • Measured inflation can vary widely, depending on factors as diverse as the choice of a price index, hedonic price adjustments, and shelter and rent accounting. For example, the consumer price index tends to overstate inflation.
  • Theories of inflation have undergone two major inflection points. The 1970s oil supply shock challenged the Phillips curve, and the collapse of money velocity after the 2008 financial crisis cast doubt on the quantity theory of money.
  • Rounds of quantitative easing (QE) since 2008 have propped up asset prices but have not produced notable inflation. This raises a related misconception about QE: Money does not create credit; credit creates money. In addition, so long as policymakers are committed to balancing their budgets in the long run, helicopter money and modern monetary theory (MMT) are not inflationary per se.
  • Currently, we believe there are fatter inflation tails than the market has expected. Longer term, there is a high probability that inflation will be contained. For investors who wish to hedge against inflation risk, we demonstrate the benefit of a portfolio approach.
  • We conclude by proposing an asset allocation framework that accounts for a variety of macro scenarios over a five- to 10-year horizon. Salient positions are a private debt overweight and a public equity underweight.

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The Author

Jamil Baz

Head of Client Solutions and Analytics

Josh Davis

Global Head of Client Analytics

Peder Beck-Friis

Portfolio Manager, Global Macro

Jerry Tsai

Quantitative Research Analyst

Ziqi Zhang

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Disclosures

The analysis contained in this paper is based on hypothetical modeling. Hypothetical performance results have many inherent limitations, some of which are described below.  No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. In fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular trading program or strategy. 

One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight.  In addition, hypothetical trading or modeling does not involve financial risk, and no hypothetical example can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses, are material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results, all of which can adversely affect actual results. No guarantee is being made that the stated results will be achieved.

The allocation models presented here are based on what PIMCO believes to be generally accepted investment theory. They are for illustrative purposes only and may not be appropriate for all investors. The allocation models are not based on any particularized financial situation, or need, and are not intended to be, and should not be construed as, a forecast, research, investment advice or a recommendation for any specific PIMCO or other strategy, product or service. Individuals should consult with their own financial advisors to determine the most appropriate allocations for their financial situation, including their investment objectives, time frame, risk tolerance, savings and other investments.

Figures are provided for illustrative purposes and are not indicative of the past or future performance of any PIMCO product.

Return assumptions are for illustrative purposes only and are not a prediction or a projection of return. Return assumption is an estimate of what investments may earn on average over the long term. Actual returns may be higher or lower than those shown and may vary substantially over shorter time periods.

We employed a block bootstrap methodology to calculate volatilities. We start by computing historical factor returns that underlie each asset class proxy from January 1997 through the present date. We then draw a set of 12 monthly returns within the dataset to come up with an annual return number. This process is repeated 25,000 times to have a return series with 25,000 annualized returns. The standard deviation of these annual returns is used to model the volatility for each factor. We then use the same return series for each factor to compute covariance between factors. Finally, volatility of each asset class proxy is calculated as the sum of variances and covariance of factors that underlie that particular proxy. For each asset class, index, or strategy proxy, we will look at either a point in time estimate or historical average of factor exposures in order to determine the total volatility.  Please contact your PIMCO representative for more details on how specific proxy factor exposures are estimated.

All investments contain risk and may lose value. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be appropriate for all investors. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses. REITs are subject to risk, such as poor performance by the manager, adverse changes to tax laws or failure to qualify for tax-free pass-through of income. Private credit involves an investment in non-publically traded securities which may be subject to illiquidity risk. Portfolios that invest in private credit may be leveraged and may engage in speculative investment practices that increase the risk of investment loss. General risks about private equity and hedge fund strategies: The strategies involve a high degree of risk and prospective investors are advised that these strategies are suitable only for persons of adequate financial means who have no need for liquidity with respect to their investment and who can bear the economic risk, including the possible complete loss, of their investment. Investors should consult their investment professional prior to making an investment decision.

Bloomberg Barclays Global Aggregate ex-USD Index provides a broad-based measure of the global investment-grade fixed income markets. The major components of this index are the Pan-European Aggregate and the Asian-Pacific Aggregate Indices. The index also includes Eurodollar and Euro-Yen corporate bonds and Canadian Government securities. Bloomberg Barclays Global High Yield Index is a component of the Multiverse Index, along with the Global Aggregate index. It represents the U.S. High-Yield, Pan-European High-Yield, U.S. Emerging Markets High-Yield, CMBS High-Yield, and Pan-European Emerging Markets High-Yield indices. Bloomberg Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. Bloomberg Barclays US Treasury Inflation-Linked Bond Index measures the performance of the US Treasury Inflation Protected Securities (TIPS) market. Federal Reserve holdings of US TIPS are not index eligible and are excluded from the face amount outstanding of each bond in the index.  Bloomberg Barclays U.S. Treasury Index is a measure of the public obligations of the U.S. Treasury.  Bloomberg Barclays World Government Inflation-Linked All Maturities Bond Index measures the performance of the major government inflation-linked bond markets. The index is designed to include only those markets in which a global government linker fund is likely to invest. This makes investability a key criterion for inclusion in the index. Markets currently included in the index (in the order of age) are, the UK (1981), Australia (1985), Canada (1991), Sweden (1994), U.S. (1997), France (1998) and Italy (2003). Bloomberg Commodity Index is an unmanaged Index composed of futures contracts on a number of physical commodities. The index is designed to be a highly liquid and diversified benchmark for commodities as an asset class. The futures exposures of the benchmark are collateralized by US T-bills. FTSE National Association of Real Estate Investment Trusts (NAREIT) Equity Index is an unmanaged market weighted index of tax qualified REITs listed on the New York Stock Exchange, American Stock Exchange and the NASDAQ National Market System, including dividends. MSCI World ex-USA Index captures large and mid-cap representation across 22 of 23 Developed Markets (DM) countries, excluding the United States. With 964 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country. MSCI Emerging Markets Index captures large and mid-cap representation across 27 Emerging Markets (EM) countries. With 1,397 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each countryThe Russell 3000 Index is an unmanaged index generally representative of the U.S. market for large domestic stocks as determined by total market capitalization, which represents approximately 98% of the investable U.S. equity market.  S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The Index focuses on the large-cap segment of the U.S. equities market. It is not possible to invest directly in an unmanaged index.

Real Estate is a custom model is designed to mimic the risk and return characteristics of an investment in levered, private opportunistic real estate based on the corresponding indices from Preqin and Cambridge Associates. Note that historical volatility on illiquid assets is understated as they are not regularly marked to market. Private Equity is a custom model where risk factor exposures are estimated through a regression on the Cambridge Private Equity Index. Adjustments are made to equity risk and liquidity consistent with empirical research on private equity managers. Note that historical volatility on illiquid assets is understated as they are not regularly marked to market. Private Credit is a custom model that represents an investment in broadly diversified private credit assets. This includes levered and unlevered exposures to residential credit, consumer finance, specialty accounts receivables financing, commercial real estate debt and private corporate lending. Note that historical volatility on illiquid assets is understated as they are not regularly marked to market. Private Infrastructure is a custom model is designed to mimic the risk and return characteristics of an investment in private infrastructure. Note that historical volatility on illiquid assets is understated as they are not regularly marked to market. Custom models: Models are provided as a proxy for asset classes where a market index is not available and are not intended or generally made available for investment purposes.

This material contains the current opinions of the manager and such opinions are subject to change without notice.  This material is distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

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