To tackle the growing risks of an inflationary environment made worse by the surge in energy and commodity prices following Russia’s war on Ukraine, investors need to target allocations to asset classes that can effectively hedge against inflation.
According to TRP research, long-term investors concerned with inflation risk or seeking real growth could consider a combination of growth-oriented and inflation-sensitive assets in strategic allocations of their portfolios.
“A strategic allocation to inflation-sensitive assets may… smooth real returns and diversify the portfolio through inflation regimes,” said Wenting Shen, portfolio manager in the global multi‑asset team at T Rowe Price.
This is essential given that the true risk for investors lies in unexpected inflation, which, by definition, is difficult to forecast.
“Unexpected inflation shocks are why inflation-sensitive assets are needed, as these assets tend to perform much better in a high or rising inflationary environment while traditional assets struggle,” added Shen.
Going for gold?
As part of their allocation decision, investors need to carefully assess the extent to which gold can hedge against inflation.
In short, it depends. “Our research shows that the same asset can display very different inflation sensitivities in different inflationary environments. More specifically, we studied if, and how, major asset classes have behaved differently toward expected and unexpected inflation,” explained Shen.
The results show that for expected inflation, short-term inflation-linked government bonds, such as US TIPS, can be a good hedge, while both long-term TIPS and gold were very poor hedges.
“For unexpected inflation, gold exhibited a strong beta to inflation, but both long and short duration TIPS fell short,” added Shen.
A wider look
Research by the firm also highlighted that many nominal asset classes – including traditional stocks and bonds – tend to directionally compensate for expected inflation, and sometimes better than inflation-sensitive assets.
Yet these nominal assets typically suffer from drawdowns during periods when inflation surprises to the upside.
“Investors in a typical stock/bond portfolio face a conundrum: when times are good and inflation rises predictably, their current asset mix should rise strongly but leaves them exposed to sudden drawdowns when inflation rises unpredictably,” said Shen.
Riding on real assets
TRP research also showed that real assets equities tend to perform better in an inflationary environment.
“A mix of commodities and real estate companies, blended together as ‘real assets equities’, exhibit similar – and in most cases, superior – inflation sensitivities to traditional inflation-linked bonds,” said Shen.
Although TIPS provide a real rate of return guaranteed by the government, the research showed that they respond much less strongly to inflation surprises and really only preserve capital that is dedicated to TIPS.
A blended approach
In line with its findings, TRP believes a mix of the right assets is key.
For example, a higher equity exposure and allocations to market segments with higher growth potential, such as small-cap stocks and emerging markets equities, can hedge against expected inflation and provide growth potential. In contrast, the real purchasing power of a nominal bond’s coupon will be lessened by the impact of inflation.
At the same time, she said investors should consider dedicated allocations to inflation-sensitive assets that should perform well in periods of unexpected or rising inflation, such as real assets equities and TIPS.
Further, while nominal bonds may not act as a good inflation hedge per se, Shen said they could still provide income and some potential downside risk management to an inflation-focused portfolio.
