EXECUTIVE SUMMARY
Inflation is one of the most significant risks to investment returns over the long term. Core equities and conventional bonds tend to deliver below-average returns in rising inflation environments, which can encourage investors to seek out inflation-sensitive assets, such as commodities, inflation-linked bonds, REITs, natural resource stocks, and gold, to protect their portfolios from inflation shocks.
In this paper, we construct a multi-asset index for inflation protection. First, we look into forecasting inflation. Next, we analyze the inflation sensitivity of various asset classes. Then, we identify strategies for different inflation regimes. Finally, we present portfolios that adjust their allocation dynamically to changes in the inflation regime.
INTRODUCTION
As record levels of monetary and fiscal stimulus are pumped into the recovering global economy, inflation has returned to the discussion. The low-inflation environment of the past few decades has penalized inflation-sensitive assets. Given that inflation can be notoriously difficult to forecast, and market participants may experience unexpected inflation shocks, it is worthwhile to revisit the concept of inflation protection.
For many investors, the unprecedented and coordinated fiscal stimulus in the wake of the COVID-19 pandemic has justified concerns over inflation. Neville et al. summarized four factors that suggest heightened inflation risk: (1) unprecedented increase in money creation, (2) historically high fiscal deficit level, (3) recent increase in long-term yields, and (4) the inflation derivatives market pricing in a 31% probability that the average inflation rate will exceed 3% over the next five years.
