Nicholas Johnson, Berdibek Ahmedov and Ronit Walny argue that now is the time to build a real asset bucket in diversified portfolios

In a multi-speed world of shifting growth and inflation dynamics, we believe investors may benefit from incorporating inflation hedging assets in their portfolios. Real assets such as inflation-linked bonds, real estate, commodities and precious metals may enhance inflation hedging and improve the diversification of investment portfolios versus investments tied to traditional asset classes such as stocks, bonds and cash. More specifically, the macroeconomic conditions that prevailed in the past 20-30 years – including persistently declining inflation and interest rates – are in the midst of a meaningful secular shift.

Policies implemented by developed country governments and central banks to address the global financial crisis have resulted in unsustainably high debt levels and zero-bound nominal interest rates – decreasing deflation and depression risk, but increasing the risk of higher inflation in the years ahead. If central banks cannot generate real growth, they will generate nominal growth; higher inflation is one way to generate the latter in the absence of the former.

All asset classes already have some degree of inflation expectations reflected in their prices; it is changes in those expectations that matter for asset prices. The greatest inflationary threat to traditional portfolios dominated by stocks and bonds is a positive inflation surprise – inflation in excess of what is already priced in. An analysis of how different asset classes have responded in periods of different levels of inflation is illustrated in the figure. It identifies five critical asset classes that respond positively, over different timeframes, to inflation and inflation surprises.

Inflation-linked bonds are tied directly to inflation as their principal is contractually linked to official inflation rates which capture inflation arising from increases in wages, education costs, medical expenses, and more. Inflation-linked bonds are most effective at protecting portfolios in a low-growth and high-inflation environment. The global universe of inflation-linked bonds has grown in recent years, with total market size at $2.5trn. All G7 sovereigns issue inflation-linked bonds and about 20% of global inflation-linked bonds are issued by emerging markets sovereigns.

Commodities such as food and energy comprise about a quarter of the CPI in developed countries, but are the most volatile CPI components (over the 10-year period to  2011 they were 53% of the annual contribution to the US CPI) and often are the cause of inflation surprises caused by unanticipated factors such as inclement weather or heightened geopolitical tensions. These volatile changes in food and energy prices are often passed through directly to consumers in the form of higher prices.

Real estate investment trusts (REITs), which pay dividends from income-producing properties, can offer a potential defence against increases in the costs of shelter. Shelter tends to constitute the largest share of average consumption baskets in the developed markets. Although REITs are not limited to housing, they provide exposure to some of the same risk factors that affect housing costs reflected in the CPI, including replacement costs and changes in interest rates. While REITs provide protection from increases in housing costs and have a high correlation to inflation over longer time periods, they have a high equity beta, which makes them less responsive to inflation surprises over shorter time horizons.

Gold has characteristics of both a commodity that is easily stored for a long period of time and a currency whose supply is limited. It can provide an added store-of-value function in the event of competitive currency devaluations: the gold coins exhibited in museums are worth far more than their face value in a currency long since extinct.

Finally, we find that inflation hedging of a portfolio can be enhanced by incorporating exposure to a basket of foreign currencies. This can help combat inflation, driven by higher prices of imported goods, brought about by weakening currencies. Currencies of emerging countries that are a significant source of imports can provide a higher degree of inflation protection.

We define inflation surprises as the difference between actual inflation at the end of the quarter and the expected inflation at the beginning of the quarter. High inflation surprise periods are represented by the top 25% of the periods in our analysis. Bonds and stocks have historically responded negatively to surprises in inflation. Bond prices tend to fall because rising inflation is associated with rising interest rates. In theory, bonds with yields linked to short-term interest rates, such as Treasuries, could move in tandem with inflation, but with the central banks keeping short-term rates near zero since late 2008 and likely to remain there for a long period, short-term instruments have become generally unresponsive to inflation.

The negative relationship between equities and inflation surprises might not seem as intuitive. Think of equities representing a discounted stream of future cash flows. When inflation rises, the discount rate applied to those cash flows rises, which lowers their current value. Higher interest rates also increase the cost of capital to corporations, and higher inflation means that earnings may be overstated since they depreciate historical cost rather than replacement cost of assets. While equities can serve many critical investment objectives, they can leave an investor with a negative inflation beta. Equities would need active management to carefully focus on companies with enough pricing power to counter the negative impact of increasing inflation rates in order to serve as an inflation hedge.

We believe investors can substantially improve the inflation-hedging characteristics in their portfolios by incorporating a basket of inflation-related assets. However, such assets provide varying degrees of positive response to inflation and inflation surprises. For example, in a stagflation environment, when growth is weak and inflation is high, inflation-linked bonds might perform the best. Conversely, when growth picks up with credit creation and the money multiplier increases in the economy, the best inflation protection could be obtained by overweighting commodities and REITs. Therefore, investors can further enhance their portfolio returns by implementing tactical adjustments to their static real asset allocations.

Nicholas Johnson is an executive vice-president and portfolio manager; Berdibek Ahmedov is a senior vice-president and product manager; and Ronit Walny is a vice-president and product manager, all at PIMCO