Inflation & Asset Allocation: Asset Classes Performance During Inflationary Shocks
- Andrea Manzi
- 8 nov 2021
- Tempo di lettura: 4 min
Aggiornamento: 9 nov 2021
Introduction: Quick Introduction on Inflation and Financial Correlation
During last year, we have seen plenty of articles about inflation, especially after seeing
the Consumer Price Index rise as much as 5.3% for the 12 months ending August 2021.[1] Among investors, it has frequently been debated whether inflation is transitory or not. We are not going to discuss about this topic. In fact, we are going to analyze how different asset classes behaved during inflationary periods from 1990 to 2021.
First of all, are stocks the best performing asset class even when inflation spikes?
The answer is no.
Even if stocks beat inflation in the long run (Credit Suisse shows that global equities have returned an average 5.2% a year above inflation since 1900), in the short-term, rising inflation may cause equity to underperform. This is due to higher nominal bond yields which, according to the money-illusion hypothesis, are erroneously used by investors to discount real cash flows, resulting in equities that are under-priced.
The Modigliani–Cohn hypothesis says that this undervaluation should end as soon as actual nominal cash flows are revealed, granting future higher returns during strong inflationary times. Growth stocks tend to suffer more for this reason, since their valuation is typically based on earnings many years out in the future.
As we can see in the table below, regardless the market capitalization (higher capitalizations are associated with lower performance in this data set), Growth always has a stronger negative correlation with inflation compared to Value[2].
Analysis Of The Main Five Portfolios
Based on our analysis purpose , we selected these five portfolios:
Ray Dalio All Seasons
David Swensen Lazy Portfolio
Stocks/Bonds (60/40)
Stocks/Bonds (40/60)
Growth Portfolio
Asset Allocation
In the first phase we reported each portfolio asset allocation, using ETF's trackers.
Return Based Style Analysis
Our second step was to analyze the portfolio style by category. This data has been useful to understand the performance results during the selected timeframes.
Performance report notes:
*Our portfolio performance analysis had the goal to underline how different asset allocation led to contrasting returns.
Results have been calculated from march 2006 to November 2021, starting from an initial invested capital of 10.000$ with annual rebalances, and no cashflows.
The software took into account dividend reinvestments.
CPI TREND ANALYSIS
Our CPI data goes from January 1990 to October 2021.
During these years we focused mainly on:
2007-2009:
Global financial crisis caused by sub-prime mortgages default
This liquidity crisis led to issues on the demand side.
2020-2021:
Covid crisis caused a global shutdown
Monetary policies were more aggressive than 2008.
This CPI spike was related to supply problems
CPI TRENDS
Using this chart, we understood that 2008 CPI monthly changes, calculated as yearly rolling sum, reached the highest values from 1990 to 1991,2007 to 2008 and 2020 to 2021.
Asset Class Performance Related To CPI Changes
We then reported the monthly performances of each portfolio components, and observed how they behaved in each CPI change scenario from 1990 to 2021.
The main take-aways from the chart are:
General level of performance decreased as the CPI Change increased
Performances on the highest CPI change month are compressed and mainly all negative.
Performances on the opposite side, are more dispersed and mainly all positive
On highest CPI Inflation month, the best performer, DBC (Invesco DB Commodity Index Tracking Fund) is also the worst performer during highest decrease of CPI inflation month.
VGSIX and VEIEX were respectively the best and worst performers, on monthly basis, for opposite scenarios. VGSIX (Vanguard Real Estate Index Fund Investor Shares) and VEIEX (Vanguard Emerging Markets Stock Index Fund Investor Shares) Our interpretation is that, when inflation rises, investors tend to choose less risky assets, while on deflationary contests, prices are more affordable, therefore Real Estate offers more opportunities.
Portfolio Correlation with CPI Inflation changes
The purpose of this tab was to attribute the correlation weight of each asset, then weighting the data and then obtaining as output, the total correlation with CPI changes.
CPI Changes. Relation with the selected asset classes
The goal of the tab is to underline the performance of each asset class during opposite periods of CPI Inflation phases.
The two asset classes, DBC and VTI, so Invesco DB Commodity Index Tracking Fund and Vanguard Total Stock Market Index Fund, had the most positive aggregate returns in terms of standard deviations compared to other asset classes returns.
The two asset classes, IEF and GLD, so iShares 7-10 Year Treasury Bond ETF and SPDR Gold Shares, had the most negative aggregate returns in terms of standard deviations compared to other asset classes returns.
So we elaborated Portfolio Simulations, built with 5 asset classes:
Most CPI Positively Correlated
Most CPI Negatively Correlated
N Different allocations with the less inter-correlated assets available
Portfolio simulations with selected asset classes
Performance results in selected timeframes:
Long Term result: Better keep it simple
2. Aggregate performances since 2006
3. Main performance data:
Conclusion
Our goal was to analyse how different asset classes behaved during inflationary shocks.
From our models the results show that the "Top Portfolio", which is composed by the five most positive correlated asset classes to CPI Inflation, performed better than every other analysed portfolio during times with unexpected positive inflation, while in the long run:
Growth Portfolio and Stock/Bonds (60/40) are the two top performers with aggregate returns of 135.38%, 134.58%
'Simulated Top' performed better than all the other simulated portfolios, but it had the worst Risk/Return ratio among all the analysed portfolios.
Ray Dalio 'All Seasons' Portfolio had a slightly better aggregate return than the 'Simulated Top' and carried the best max drawdown (-11.97% vs Simulated Top's -44.35%)
In conclusion, even if certain asset classes perform best during inflationary spikes, we should not base our portfolio only on these assets.
Instead, we should include them with the right weights in order to hedge our portfolio against unexpected inflation spikes.
Authors:
Disclaimer:
This post was prepared by Andrea Manzi and Lorenzo Galli in our personal capacity.
The opinions expressed in this article are the author's own and do not reflect the view of the company or the university. Website and the information contained here are not intended to be a source of advice or credit analysis with respect to the material presented, and the information and/or documents contained in this website do not constitute investment advice.
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