Unexpectedly high inflation is a real possibility and investors shouldn’t expect protection from a traditional mix of stocks and bonds.
AQR researchers argue in a new paper that both stocks and bonds have worse-than-average returns during inflationary environments and investors should consider adding alternative investments, such as global macro and trend following strategies, for protection.
In the research paper, AQR studied how equities, fixed income, and real assets react to inflation. Using the time period between 1972 and 2021, the alternatives manager found that domestic equities, 10-year U.S. treasuries, and a 60 percent-40 percent combination of the two all had negative sensitivity to an inflation metric. That means, “both components of traditional stock-bond portfolios have tended to underperform when inflation rises, indicating a concentrated exposure to upside inflation shocks,” wrote the paper’s authors.
AQR attributes the negative correlation between the stock market and inflation to several factors. For one, investors might take inflation into consideration when calculating the present value of future cash flows. But, most importantly, consumers may be reluctant to spend in a highly inflationary environment.
“Economic activity, investment, and consumption might be lessened in a period where economic uncertainty is greater,” said Ashwin Thapar, one of the paper’s authors and principal at AQR.
AQR then evaluates some traditional inflation hedges, such as real assets. It looks at U.S. real estate, whose revenues can rise with inflation, a basket of commodities, whose prices can also rise during these periods, and inflation-linked bond strategies, including holding Treasury Inflation Protected Securities, or TIPS. AQR also evaluates what it calls an inflation breakeven investment, essentially the pairing of a long position in TIPS with a duration-matched short position in Treasuries.
AQR found that commodities and a breakeven inflation strategy stand out with “a meaningful positive inflation sensitivity.”
The commodities market “very much moves with inflation,” Thapar explained. In fact, “Sometimes commodity prices are the cause of inflation.”
Breakevens, which involve combining two fixed income investments simultaneously, are a fairly direct tool for investors to bet on rising inflation, and can serve as “a tactical bet on inflation,” according to Thapar. “If someone is really concerned about inflation and really wants to make a targeted investment, inflation breakevens are the way to go.”
The alternatives firm also finds that investors can meaningfully protect their 60-40 portfolios by allocating to a real-return strategy made up of 25 percent risk allocation to inflation breakevens, commodities, trend, and macro momentum.
“If you are thinking about long-term asset allocation, I would advocate adding commodities or other compensated real assets,” Thapar said.