The inflation trade-off
Hedging against unexpected inflation can be costly. But Karsten Jeske and Anjun Zhou argue that active management can shift the efficient frontier in investors’ favour
While inflation and inflation volatility were relatively subdued until the late 1990s, inflation volatility has picked up again in the 2000s. Evidence shows us that more uncertainty about inflation lies ahead.
Highly accommodative fiscal and monetary policy, in our view, significantly increases the risk of unexpected inflation, which has historically had a negative impact on equity and bond prices. Meanwhile, we believe asset classes such as commodities and commodity-sensitive equities can help to alleviate this risk.
Unexpected inflation (UI) is defined as the difference between realised inflation and inflation expectation for the same period. We examine the sensitivity of asset class returns to UI through a simple measure called ‘UI beta’. These betas, along with our estimates of expected returns.
Nominal bonds, proxied by the Barclays US Aggregate Bond index, have a large negative UI beta. Their returns typically react negatively to UI, when short-term interest rates rise and lift the yield curve. This impact is amplified through duration and incorporated into bond prices. In contrast, US TIPS are largely insensitive to UI. Literature suggests that the biases of inflation indices that TIPS are linked to may understate inflation to the detriment of investors.
Global equities, proxied by the MSCI World index, also have a negative UI beta. While equities can be a decent inflation hedge in the long run, normally, UI negatively affects equities in the short term. One plausible explanation is that, due to countercyclical monetary policy, inflation adversely affects equity prices when financial markets price in the prospect of tighter monetary policy. That said, some equity sectors display significantly positive UI betas, particularly those related to resources such as gold mining and oil and gas, because financial markets re-price equity prices to reflect expectations about future commodity prices. Note that REITs, which are backed by real assets, also have a positive, albeit smaller, UI beta.
All four major commodity sectors have significantly positive UI betas. The main reason, in our view, lies in the different degrees of ‘price rigidity’ of commodity prices and prices for goods and services in the consumption basket. While consumer prices generally experience infrequent updates, commodities are traded in liquid markets and respond to changes in economic conditions and expectations instantaneously. With the inherent delay in consumer prices, commodities have the ability to ‘front-run’ consumer prices, hence their high UI betas.
Certain private investments, such as infrastructure and real estate, also tend to have non trivial positive UI betas. Practically, though, these illiquid investments are unlikely to provide effective inflation hedging in a timely manner, so whether private investment should be considered part of the UI hedging tool kit depends on one’s objectives and constraints. If liquidity and transparency are important portfolio objectives, publicly traded vehicles, such as commodities and public equities, would be desirable choices.
Since both equities (other than commodity-sensitive equities) and bonds generally have negative UI betas, a portfolio comprised mainly of equities and bonds can perform poorly when UI rises. Should an investor who becomes concerned about UI risk then move the bulk of the portfolio into assets with high UI betas? Yes. However, there is a tradeoff.
Suppose we start with a sample institutional portfolio of 60% MSCI World index and 40% Barclays Aggregate index, which has a negative UI beta. To reduce UI risk, one must move southwest on the diagram, to where some of the commodity sectors reside. In exchange for inflation protection, investors would have to give up expected returns.
To effectively evaluate this tradeoff, we expand the classic efficient frontier into a three-dimensional efficient frontier surface, which is designed to represent the optimal tradeoff among expected return, portfolio risk and UI risk. From this 3D surface, we specify a portfolio volatility target and derive what we call the UI efficient frontier, which generally details the inherent tradeoff between UI risk and expected return. Investors who prefer to take on less UI risk would have to sacrifice the expected returns of their portfolios.
While this kind of return/UI risk tradeoff is common for a portfolio with passive investments, we believe it can be mitigated, particularly through active commodity allocation, equity sector restructuring, and self-financing overlay at the plan level – which are some solutions for UI hedging that seek to combine positive UI betas and higher expected returns than are typical for passive commodity indexes. As a result of these programmes, the UI efficient frontier has the potential to be lifted upward and outward.
Karsten Jeske is a senior research analyst and Anjun Zhou is head of multi-asset research at Mellon Capital Management Corporation, a BNY Mellon investment manager