Deflating Inflation
Deflating Inflation
Redefining the Inflation-Resistant Portfolio
n
What assets provide the best
defense against inflation?
n
How much and what type of
inflation protection should an
investor seek?
April 2010
Investment Products Offered
• Are Not FDIC Insured • May Lose Value • Are Not Bank Guaranteed
n
How to assess the inflationary
landscape and when to implement
an inflation protection strategy
Table of Contents
1
Key Research Conclusions
2
Introduction
Inflation Protection…Why Bother?
5
How to Hedge Inflation
What Assets Provide the Best Defense?
18
Getting Real
Incorporating Inflation Protection in the Portfolio
26
Monitoring the Temperature of Inflation
When to Implement a Protection Strategy
30
Appendix
Further Details on How Different Assets Respond to Inflation
Key Research Conclusions
Most investment portfolios are not designed with inflation risk
explicitly in mind. As a result, many investors are often dangerously susceptible to an unexpected rise in inflation, which can
present one of the most pernicious environments for traditional
portfolios. What’s worse, at the same time that many investors’
assets are hit by an inflationary spike, their liabilities or living
costs tend to rise. Such a double whammy can leave investors in
a deep hole.
There’s a good deal of confusion and disagreement about how
best to protect against inflation, both in terms of what assets
hedge inflation most effectively and how to incorporate them
in a portfolio. This paper provides a framework for analyzing
the inflation-hedging decision. Our research shows that:
n
While many different assets could potentially hedge against
inflation, their effectiveness varies, as do their reliability and
their cost-effectiveness.
n
Arbitrarily incorporating inflation hedges could markedly shift
the otherwise carefully constructed risk/return profile of a
portfolio. We found that a suite of real investments—which
effectively serve as complements to one’s existing “nominal”
asset allocation—provides the most efficient means of
hedging against inflation risk without detracting from the
portfolio’s other goals.
n
Finally, because each investor’s liabilities and portfolio
objectives are different, there is no single inflation protection
formula that is “right” for all investors. The key factors
driving the appropriate amount and type of inflation protection are the investor’s risk tolerance and overall vulnerability
to adverse inflation surprises.
Incorporating inflation protection will likely cost a little bit over
time (in terms of forgone returns), but in the event of an
unexpected inflationary shock, it should provide valuable
protection by reducing the large loss in purchasing power that a
traditional stock/bond mix is likely
to suffer. n
Deflating Inflation: Redefining the Inflation-Resistant Portfolio
1
Introduction
Inflation Protection…Why Bother?
The recurring pattern in Display 1 gauges the devastation
wrought by such episodes. The circled blue bars indicate all
the 10-year periods in the US from 1900 to the present when
a hypothetical well-diversified portfolio—comprising 60% stocks
(represented by the S&P 500) and 40% bonds (represented by
10-year Treasuries)—generated negative inflation-adjusted (or
“real”) returns. The green bars represent rolling 10-year
annualized rates of inflation, and the shaded gray areas at the
top designate inflation spikes—periods when there was a threepercentage-point increase (or more) in the rate of inflation over
the prior 10 years. The spikes in inflation coincide with the
decade-long collapses in real portfolio performance.
Perhaps surprisingly, even during the Great Depression (the
highlighted deflationary era during the 1930s), investors fared
better at generating positive inflation-adjusted returns than they
did during periods of escalating inflation. To be sure, portfolio
values plummeted during the Depression, but so did prices for
almost everything else, leaving the real purchasing power of a
traditional 60/40 portfolio (as defined above) relatively intact. By
contrast, during the three inflationary periods over the last 100
years, the real value of a diversified portfolio dropped sharply.
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Display 1
Inflation Spikes Decimate Traditional Stock/Bond Portfolios
Inflation and Negative 60/40 Real Returns
Rolling 10-Year Annualized
WWI Spike
WWII Spike
1970s Spike
10
Percent
Philosopher and poet George Santayana famously remarked,
“Those who cannot remember the past are condemned to repeat
it.” While he almost certainly didn’t have inflation in mind when
he made this assertion, investors should find the aphorism no less
relevant. Indeed, although inflation shocks haven’t been a
dominant feature of the developed world landscape in nearly a
generation, the historical record warns us that when they have
struck, they’ve done so with terrible force, leaving ruined investment portfolios in their wake. Put simply, the history of inflationary
episodes is a past that no investor should hope to repeat.
5
0
–5
Deflation
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
Inflation
Negative 10-Year 60/40 Real Returns
This is a hypothetical example and is not representative of any AllianceBernstein
product. Individuals cannot invest directly in an index.
The portfolio comprises 60% stocks and 40% bonds; stocks are represented by the S&P
500 (with a Global Financial Data extension) and bonds by 10-year Treasuries.
Inflation is measured by US CPI, US City Average, all items, not seasonally adjusted.
Source: Global Financial Data (GFD), US Bureau of Labor Statistics (BLS), and
AllianceBernstein
What’s more, the compounding effect of negative real returns,
coupled with the fact that many investors need to tap their
portfolios to support their spending (which itself is typically linked
to inflation), can cause a massive loss in portfolio purchasing
power over time. For example, in the US by the early 1980s—
when the 10-year rate of inflation reached 9%—a 60/40 portfolio
would have experienced a real return of –3.5% on an annualized
Display 2
Inflation Causes Massive Decline in Real Portfolio Value
US
1972–1982
UK
1910–1920
Japan
1946–1956
9%
11%
23%
60/40 Stock/Bond Real Return*
–3.5%
–9.3%
3.3%
Decline in Real Portfolio Value (After Spending)
–65%
–86%
–52%
10-Year Inflation Rate*
This is a hypothetical example and is not representative of any AllianceBernstein product. Individuals cannot invest directly in an index.
*Annualized
Assumes 60/40 stock/bond allocation, with 4% annual spending rate on initial portfolio value (spending grown with inflation). Inflation is represented by the respective inflation
indices of the US, the UK, and Japan. Stocks in the US are represented by the S&P 500 Index; in the UK, by the FTSE All-Share Index; and in Japan, by the Nikko Securities
Composite. Bonds are represented by the 10-year government bond indices of the US, the UK, and Japan, respectively.
Source: BLS, GFD, and AllianceBernstein
basis (Display 2). Add in a typical spending rate of 4% a year from
the portfolio, and almost two-thirds of an investor’s real wealth
would have vanished by the end of the decade.
In Britain in the decade surrounding World War I, the same rate
of spending, combined with inflation at 11%, resulted in even
worse portfolio performance: Nearly 90% of the investor’s real
wealth would have been eaten away. The post–World War II
story in Japan is similar: Even modestly positive portfolio real
returns failed to overcome the extreme rates of inflation
endured during the early years of that decade, and real portfolio
value declined by more than half. Simply put, traditional
stock/bond portfolios do not adequately defend against the
calamity of adverse inflation surprises and can leave investors in
a deep hole.
The Current Inflation Fixation
The debate about the direction of future inflation and the
damage it can cause a portfolio has become increasingly
fraught of late. The massive fiscal and monetary expansions deployed in response to the global financial crisis have prompted
many investors to think about how vulnerable they are to an
inflation shock and how to protect their portfolios. Many have
rushed headlong into assets generally considered to be strong
inflation antidotes, such as gold and inflation-protected bonds.
Unfortunately, however, there’s little consensus and much
confusion about how best to protect against inflation risk.
It’s important to note that while many different assets could
potentially provide some protection against inflation, their ability
to do so varies, as do their reliability and their prospective cost,
particularly when measured in terms of the expected returns
they provide compared with what they’re replacing in the
portfolio. Also, arbitrarily incorporating one or more of these
assets could markedly shift the otherwise carefully constructed
risk profile of any portfolio. Finally, because investors’ liabilities,
risk tolerance, and portfolio objectives differ, there’s little reason
to believe that a “one size fits all” inflation protection formula
could be devised that would be “right” for every single investor.
Our goal here is to clear up some of the confusion surrounding
these issues. We aim to provide insight into the tools available
to protect against inflation risk and how an inflation-hedging
strategy might be best implemented in light of one’s broader
investment objectives.
Incorporating An Inflation Hedge in the Portfolio
One of the key insights emerging from our research is that it is
possible to build an effective suite of inflation hedges that can
fit seamlessly into a traditional portfolio, without causing undue
distortion to its prior risk profile. Because many investors already
frame the essential building blocks of their asset allocation
construction in terms of cash, bonds, and stocks, a parallel
complement of inflation hedges makes holistic portfolio sense.
In other words, we believe the same goals of any traditional
Deflating Inflation: Redefining the Inflation-Resistant Portfolio
3
Display 3
Real Investments Complement Traditional Counterparts
“Traditional” vs. Inflation-Protected Allocation
100
Percent
80
60
Diversified
Stocks
Diversified Real
Stocks Assets
Commodities,
Real Estate, FX,
Commodity-Related
Equity Investments
40
20
0
Diversified
Bonds
Cash
Traditional
Allocation
Diversified Real
Bonds Bonds
Intermediate-Term
Inflation-Linked Bonds
Cash Real Cash
Short-Term
Inflation-Linked Bonds
Inflation-Protected
Allocation
For illustrative purposes only
Source: AllianceBernstein
allocation (in terms of balancing its risk and return objectives)
can be achieved in a corresponding inflation-protected allocation (Display 3).
We categorize these inflation hedges in three broad buckets:
Real Cash, Real Bonds, and Real Assets. Lower-volatility Real
Cash and Real Bond portfolios are represented by short-term
and longer-term inflation-linked bonds, respectively, while Real
Asset portfolios encompass a variety of higher-risk inflation
hedges (including real estate, commodity-related stocks,
commodity futures, and foreign currency exposure).1 This
approach can readily be tailored to an investor’s existing risk
appetite by simply introducing the appropriate amount of
inflation-protecting or “real” equivalents into the existing
“traditional” allocation. But as we will detail in this study, since
each of these hedges has distinctive virtues and shortcomings,
most investors will want to fine-tune their inflation-hedging
strategy to reflect their own unique needs.
The second major conclusion stemming from our research is that
adding inflation protection to a traditional asset allocation is
unlikely to improve expected returns. Inflation protection does
have a cost in terms of forgone returns. But, the protection it is
designed to provide—reducing the loss in purchasing power that
a traditional stock/bond mix would likely suffer—is valuable
should an inflationary shock occur.
With this “hedging” perspective in mind, we detail in the
following pages a framework whereby investors can:
n
Assess which financial assets may most effectively protect
against inflation, either alone or in combination;
n
Determine the type and amount of inflation protection
needed, as well as the least intrusive way to embed it in the
portfolio; and
n
Evaluate the current inflationary landscape and determine
when might be the right time to implement an inflation
protection strategy. n
Chapter Highlights
n
Most investors need some form of inflation protection; the proper type and amount depend on their circumstances.
n
While inflation hedges will cost a little in performance on average, they will help protect the portfolio against the
devastation that inflation can bring.
Note that the Real Assets category is also appropriate for investors with allocations to certain “alternative” investments. We see some illiquid real investments (such as direct real
estate) as viable substitutes for liquid real investments (such as REITs) for investors willing to assume liquidity risk.
1
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AllianceBernstein.com
How to Hedge Inflation
What Assets Provide the Best Defense?
It’s not an easy matter to determine which assets provide the
best defense against inflation. In part, this is because long-term
performance records across different inflationary cycles do not
exist for many asset classes.2 We’ve been able to overcome
some of these limitations by building our own, proprietary
historical data series for commodity returns, and by constructing a hypothetical return series for inflation-linked bonds
stretching back more than a century (see sidebars on pages 8
and 14). But even apart from the dearth of data available in
conventional investment databases, we should expect most
inflation hedges to vary significantly in their effectiveness across
time and across different inflationary episodes. Therefore, to
build an effective portfolio of inflation hedges, it’s critical to
understand the key drivers of each asset and its fundamental
response to changes in inflation.
We identified three key factors that help us determine the
effectiveness of any prospective inflation hedge:
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Its sensitivity to inflation
n
Its reliability as a hedge
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Its cost-effectiveness
We measure an asset’s inflation sensitivity by quantifying the
average impact of an increase in the inflation rate on the asset’s
total return. We call this measure an asset’s “inflation beta.” All
else equal, the higher an asset’s inflation beta, the stronger its
appeal as an inflation hedge. But in addition to its beta, we
need to consider the reliability of any prospective hedge, since
having a high inflation beta is of limited value if the protective
benefit works only some of the time. Finally, inflation hedges
come with a cost (measured primarily by the expected return
sacrifice relative to a traditional investment with similar volatility). Minimizing that cost should be part of any sensible inflationhedging strategy.
Inflation Sensitivity
There are generally two opposing forces that drive an asset’s
sensitivity to inflation, or inflation beta. On one hand, inflation
can have a positive impact on an asset’s value when rising prices
also result in rising cash flows (Display 4, left, following page).
For example, the revenues of many commodity-related companies “pass through” inflation relatively efficiently. To the extent
the costs such companies face react less strongly to an inflation
surprise, they should be able to pass those rising prices through
to the bottom line.
But rising inflation also damages asset values because it is a
proxy for rising inflation expectations, a key driver of the
discount rate used to gauge the present value of future cash
flows. Higher discount rates cause the market to devalue an
asset, because future cash flows are worth less in today’s money
(Display 4, right, following page). The further out in time any
fixed cash flows extend, the greater the asset’s sensitivity to
For example, inflation-linked bonds are a recent innovation. In the US, Treasury Inflation-Protected Securities, or TIPS, were first offered in the late 1990s; inflation-indexed
“Linkers” in the UK date back to the early 1980s.
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Deflating Inflation: Redefining the Inflation-Resistant Portfolio
5
Display 4
Display 5
Rising Inflation Has a Dual Impact on Asset Returns
Inflation Sensitivity Varies by Asset Class
Asset Class Inflation Betas
1965–2009
Positive Return
Impact
6.5
Cash Flow
Rise
Discount Rate
Rise
Negative Return
Impact
For illustrative purposes only
Source: AllianceBernstein
discount rate fluctuations. It’s the net impact of these two
phenomena—greater expected cash flows and higher discount
rates—that determines an asset’s behavior in an environment of
rising inflation.
Inflation sensitivity across a range of assets can vary significantly (Display 5).3 In the US, for example, for a given 1%
increase in the inflation rate, 20-year nominal bonds fell 3.1
times as much. Stocks, too, tend to be vulnerable to most
rising inflation environments: On average, the S&P 500
historically dropped 2.4 times the rise in inflation, and the
broad equity indices of many other countries showed a similar
sensitivity. This helps explain the dismal performance we saw
in the traditional 60% stock/40% bond portfolio during
periods of accelerating inflation. There are some assets,
however, that have tended to post positive returns in a rising
inflation environment, including T-bills, inflation-linked bonds,
certain types of real estate, and commodities. But first let’s
explore equities a bit further, to see just what’s driving these
returns. (For more information on how various assets may
react to accelerating inflation rates, see the Appendix, pages
30–35.)
3Given
0.3
–3.1
0.8
1.7
–2.4
20-Yr.
S&P 500
US Treasuries
3-Mo. T-Bills 10-Yr. TIPS* Farmland† Commodity
Futures‡
Historical analysis is not a guarantee of future results. Individuals cannot invest directly
in an index.Total return beta to one-year inflation rate change in multivariate regression
including lagged inflation rate.
*10-year Treasury Inflation-Protected Securities (TIPS) are calculated from synthetic
AllianceBernstein real yields estimated from actual inflation and nominal yield curve
variables before 1999 and from Federal Reserve real yields thereafter.
†Farmland is the national average value per acre as determined by the US Department
of Agriculture (USDA).
‡Commodity futures prior to 1990 are on a US consumption–weighted basis and are
sourced from AllianceBernstein series prior to 1970 and from the MJK Commodity
Futures Database between 1970 and 1990; they are represented by the Dow JonesUBS Commodity Futures Index (DJ-UBS) thereafter. All futures returns are fully
collateralized by T-bills unless otherwise indicated.
Source: DJ-UBS, Federal Reserve, GFD, London Times, MJK Associates, The
New York Times, USDA, The Wall Street Journal, and AllianceBernstein
Taking Stock of Equities in Inflation
Stocks are often considered a relatively robust inflation hedge.
But while it’s true that diversified equities can overcome
inflation over very long horizons, their record as a hedge against
accelerating inflation over the short to medium term is poor.
This comes as a surprise to many investors, who correctly point
out that as long as a company’s expenses (the largest component of which are usually “sticky” wages) don’t increase at the
same pace as its revenues, the wider profit margin will translate
into greater cash flows. In fact, S&P 500 data show that equity
earnings do tend to grow faster—more than 6% faster than
average—in years when inflation accelerates (Display 6, left).
the availability of data for multiple asset classes and the ability to confirm our conclusions across many different countries, we show results from 1965 to the present in many
of the displays that follow. Our longer-term US data were then used to corroborate these indications where applicable.
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AllianceBernstein.com
So companies will see higher cash flows in such an inflationary
environment, but the market will generally apply a higher
discount rate to those cash flows. Which effect dominates
valuations: higher expected cash flows or the higher discount
rate? According to the long-term history of the S&P 500 in the
US, in years when inflation accelerated, price/earnings multiples
tended to drop, on average, by 1.4 points (Display 6, right).
However, there are exceptions to this. For example, in extremely
low or negative inflationary environments, an increase in
inflation expectations tends to coincide with an increase in
equity prices, resulting in positive inflation betas. This anomaly
occurs because as inflation moves from abnormally low levels
back toward more normal levels, general economic uncertainty
falls—and, with it, risk premia of all types.
But most of the time, and for most stocks, the ability of
companies to pass through price increases is more than offset
by the negative influence of higher discount rates—which is
why diversified equity indices in nearly every country we studied
have a negative inflation beta. That said, some equity sectors,
such as natural resources and real estate, have historically
exhibited less-negative (or even positive) inflation betas than
diversified stocks. What these sectors tend to have in common
is high capital intensity: They have such high fixed costs that
when inflation accelerates, margin expansion often overwhelms
the opposing discount rate impact.
Seeking High Inflation Betas Across an Array of Assets
Nominal bonds also perform poorly in rising inflation environments: Their future cash flows are fixed, so a rising discount rate
(due to higher expected inflation) damages the current value of
the bond. In general, the longer the bond’s maturity, all else equal,
the more vulnerable it will be to changes in inflation expectations.
Short-maturity bills perform better than their longer-maturity
counterparts during rising inflation, because the yields of new bills
will discount higher inflation expectations when inflation spikes. In
other words, the shorter the maturity of nominal bonds, notes,
and bills, the more quickly investors are able to reinvest in new
instruments that reflect any changes in inflation expectations.
Inflation-linked bonds (“ILBs” for short), such as US TIPS and UK
“Linkers,” are designed to simply pass through changes in
consumer or retail price indices, CPI and RPI, respectively. As
measured by our synthetic series, ILBs would have delivered
inflation betas of nearly 1.0 over time. The reason we estimate
the beta for ILBs at generally slightly below 1.0 is because a rise
in inflation sometimes dovetails with a rise in real interest rates,
which damages the value of a fixed income investment.4 Our
research suggests that this was the case in the US during the
late 1970s and early 1980s, a time of both heightened concern
over the country’s monetary stability and, in response, tightening central bank policy. We estimate that during this period, the
fall in the price of inflation-linked bonds due to higher real
Display 6
Rising Inflation Leads to Higher Earnings…
…but a Higher Discount Rate Hurts Valuations
S&P 500 Earnings per Share Growth vs. Average
S&P 500 Price/Earnings Change
6.2%
2.5×
–1.4×
–5.9%
Decelerating
Inflation Years
Accelerating
Inflation Years
Decelerating
Inflation Years
Accelerating
Inflation Years
Historical analysis is not a guarantee of future results. Individuals cannot invest directly in an index.
Average year-over-year growth, 1930–2008
Source: Robert J. Shiller, Irrational Exuberance, Princeton University Press, 2000; and AllianceBernstein
Also, inflation-linked bonds in most countries have a short contractual lag in passing through actual inflation, which could further weaken the measured inflation beta.
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Deflating Inflation: Redefining the Inflation-Resistant Portfolio
7
Re-Creating the History of Inflation-Linked Bonds
Although inflation-linked bonds (ILBs) form a crucial
component of most inflation protection strategies, the
historical record necessary to judge how ILBs may behave in
disparate economic environments does not exist. The United
Kingdom was the first to issue such bonds—called Linkers—
in the early 1980s, followed by Sweden, Canada, and
Australia; eventually the US issued Treasury InflationProtected Securities—TIPS—in the late 1990s. Because
inflation has been comparatively stable during this relatively
brief period, we decided to construct a synthetic ILB return
series extending back to the 1890s* to gain better perspective on how these instruments might have performed in
different inflationary environments.
The key to creating a synthetic ILB series is to understand
how inflation expectations are formed. Nominal government
bond yields can be decomposed into a real yield, expected
inflation, and an inflation risk premium earned for bearing
the uncertainty around whether actual inflation will meet
expectations. If inflation expectations are known, then the
real yields that ILBs offer can be estimated by subtracting
inflation expectations and the estimated inflation risk
premium from nominal yields. Fortunately, because inflation
expectations are a function of historical experience—like
most expectations, they are largely backward-looking—they
can be reliably estimated historically.
US Inflation Expectations
UK Real Yields
US Model Estimates of Survey Inflation Forecasts
US Model Estimates of UK Real Yields
One-Year US CPI Forecasts
10-Year Linker Yields
5
12
4
Estimated
Forecast
Percent
Percent
9
6
3
Actual
Forecast
3
2
Estimated
Real Yield
1
0
1970
Actual
Real Yield
0
1980
1990
2000
2010
Historical analysis is not a guarantee of future results. Estimate based on actual US
inflation and yield curve variables.
Source: Federal Reserve and AllianceBernstein
1989
1994
1999
2004
Historical analysis is not a guarantee of future results. Estimate based on actual
UK inflation and yield curve variables.
Source: Bank of England, Federal Reserve, and AllianceBernstein
*Due to the paucity of reliable long-term non–US capital markets data, our analysis throughout takes a largely US investor perspective. Where possible, we have
conducted analyses from different country perspectives. The conclusions herein should be relevant to most countries around the globe.
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AllianceBernstein.com
2009
The display on the left of the facing page shows how
accurately one-year consensus inflation expectations can be
estimated with nothing but backward-looking knowledge of
actual inflation. The blue line shows surveyed consensus
expectations, while the green line shows an estimate of
expectations based on weightings to various measures of
actual trailing inflation. Because actual inflation data can be
sourced going back to the 1800s, we can estimate where
expectations likely were at any point in time, and, with that,
where real yields were.† To gauge the validity of this
approach, we applied our US-based weightings to UK data
and compared the resulting estimates of UK real yields to
actual UK real yields, as shown in the display on the right of
the facing page. The close fit suggested that our synthetic
real yield series was robust enough to calculate ILB returns
for implementation in our asset allocation work.
In addition, using this much longer, synthetically constructed time series of inflation expectations, we were able
to explore a number of long-unsolved investment questions—such as whether expectations drive actual inflation.
We found that the impact of inflation expectations on
actual inflation likely varied with the level of inflation.
Anecdotal evidence from Japan suggests that consumers
put off purchases when there are expectations of future
deflation, resulting in a weaker economy and a selffulfilling prophecy of more deflation. Our research on US
inflation indicates that in high-inflation environments (CPI
greater than 5%), the pass-through of inflation expectations to actual inflation is twice as large as it is in lowinflation environments (CPI between 0% and 5%). n
†A structural break in how inflation expectations in the US were set occurred
between World War II and the 1970s with the transition away from a gold
standard. Including various nominal yield curve variables allowed us to adjust for
this break and extend our series back to the gold standard era.
interest rates would likely have offset some of the positive
benefits of the contractual inflation accrual, thereby diminishing
returns. The relationship between inflation and real yields is
therefore a key question in determining the efficacy of inflationprotected bonds as an inflation hedge. Although inflationprotected bonds could produce negative returns in the event of
a large spike in both real yields and inflation, they would still
outperform traditional bonds, which would do even worse. (For
more on inflation-linked bonds, see the Appendix, pages 31–32.)
Some investments—what we term “real assets”—have
empirical and expected inflation betas greater than 1.0. For
example, some real estate assets throw off cash flows tightly
linked to inflation and so tend to have high inflation betas.5 The
cash-flow sensitivity of real estate stems from both the proportion of value tied up in land (i.e., the proportion of costs that
are fixed) and the sensitivity of “rents” to inflation. Generally
speaking, the higher the proportion of land in a real estate
asset’s value, the higher its inflation beta. And for most types of
residential and commercial properties, rents take the form of
fixed lease payments—so in general, the shorter the lease term,
the greater the inflation sensitivity. Agricultural properties such
as farmland also serve as good inflation hedges because their
“rents” (in the form of farm product and timber prices) vary
directly with inflation-sensitive agricultural commodity prices.
The investment that ranks best by far in terms of inflation beta is
commodity futures. A broadly diversified basket of commodity
futures exhibited an inflation beta of 6.5 from 1965 to the
present. (This is from a US investor’s point of view; it would differ
from the perspective of investors in other countries. See the
Appendix, pages 33–34, for more information.) That’s because
commodity futures returns tend to embed a high sensitivity to
shorter-term supply-and-demand economics. An overheating
economy often goes hand in hand with both rising inflation and
price and inventory pressures in the commodities markets,
leading to higher futures returns. Some have taken this idea
further, suggesting that commodities may well be the preferred
In our real estate research, we relied on the NAREIT Equity REIT Index since 1971 and a REIT proxy prior to that time comprising non-REIT real estate stocks and a
building cost index. The current global public real estate equity market is composed of roughly half REITs and half non-REIT real estate companies.
5
Deflating Inflation: Redefining the Inflation-Resistant Portfolio
9
“all-weather” inflation hedge. However, the performance of
commodity futures can be unreliable, and their opportunity costs
can be high.
Clearly, there appears to be a trade-off: the greater the inflation
sensitivity, the lower the reliability. What drives this uncertainty?
Why does reliability tend to be lower for higher-volatility assets,
and can we do anything about it?
The Reliability of Inflation-Hedging Assets
While an inflation beta provides some indication of the direction
and magnitude of an asset’s historical inflation sensitivity, it does
not capture the consistency of the inflation hedge. Display 7 shows
the percent of rising inflation years since 1965 when various
categories of inflation-hedging assets posted positive returns. We
estimate that Real Cash (short-maturity ILBs) and Real Bonds
(longer-maturity ILBs) provide the greatest stability: Even though
their inflation sensitivity was lower, it was very reliable. A diversified
basket of hedges from the equity sector—a category that includes
both real estate and commodity-related stocks—was less reliable,
but still delivered positive returns during periods of rising inflation
over three-fourths of the time. Then there’s the highest-inflation
beta groups, such as commodity and precious metals futures,
which had reliability akin to a coin flip—when they worked, they
worked exceptionally well, but they failed nearly as often.
The Role of Risk (and Return) for Real Assets
One reason that Real Asset inflation hedges aren’t always reliable
is that many factors beyond changes in inflation expectations
drive their returns. Predicting these factors can be difficult, and
this inherent uncertainty is reflected in an asset’s level of
volatility. While higher volatility can enhance inflation beta
(assuming a positive relationship between asset returns and
inflation surprises), it tends to reduce the reliability of the hedge.
Display 8 shows the trade-off between inflation beta and riskadjusted returns. REITs and several commodity-related equity
sectors (energy, agriculture, and metals stocks) occupy the upper
left of the display, indicating that historically they have provided
better risk-adjusted returns, but with small and sometimes even
Display 8
Real Assets: The Trade-Off Between Inflation Sensitivity and
Volatility-Adjusted Returns
Display 7
The Reliability of Inflation Hedges Varies
Inflation Betas vs. Volatility-Adjusted Returns
Percent of Rising Inflation Years with Positive Returns
1965–2009
1965–2009
84%
One-Yr.
TIPS
10-Yr.
TIPS
Real Cash
Real Bonds
76%
Commodity
Stocks
76%
REITs
54%
49%
Commodity
Futures
Precious
Metals
Futures
Real Assets
Historical analysis is not a guarantee of future results. Individuals cannot invest directly in
an index. TIPS are calculated from synthetic AllianceBernstein real yields estimated from
actual inflation and nominal yield curve variables before 1999, and they are sourced
from Federal Reserve real yields thereafter; commodity stocks and precious metals futures
are sourced from the Ken French Data Library; and REITs are represented by the
NAREIT Index. Commodity futures prior to 1990 are on a US consumption–
weighted basis and are sourced from the AllianceBernstein series prior to 1970 and from
the MJK Commodity Futures Database between 1970 and 1990; they are represented
by DJ-UBS thereafter. Commodity futures and precious metals futures are fully
collateralized by three-month T-bills.
Source: BLS, Commodity Research Bureau (CRB), DJ-UBS, Federal Reserve,
Ken French, GFD, International Monetary Fund (IMF), London Times, MJK
Associates, NAREIT, National Bureau of Economic Research (NBER), The New
York Times, USDA, US Geological Survey (USGS), The Wall Street Journal,
and AllianceBernstein
10
AllianceBernstein.com
Shortterm
TIPS
Return/Volatility
96%
0.8
0.6
S&P
500 REITs
Energy Stocks
Agriculture Stocks
Industrial Metals
Gold
0.4 Industrial Metals Stocks
Futures
Bullion
Intermed- Commodity Real Commodity Precious
Softs
Livestock
Futures
iate-Term Stocks
Estate
Futures*Gold
Metals
Stocks
Futures
0.2
TIPS
Stocks
Futures
Precious
Grain Futures
Metals
Futures
0.0
–3
–1
1
3
5
7
9
Inflation Beta
Historical analysis is not a guarantee of future results. Individuals cannot invest directly in
an index. Commodity futures prior to 1990 are on a US consumption–weighted basis and
are sourced from the AllianceBernstein series prior to 1970 and from the MJK Commodity
Futures Database between 1970 and 1990; they are represented by DJ-UBS thereafter.
Commodity-related stocks and futures are sourced from the Ken French Data Library; gold
bullion is represented by London FX, and REITs by the NAREIT Index.
Source: BLS, Ken French, GFD, London FX, London Times, NAREIT, The
New York Times, The Wall Street Journal, and AllianceBernstein
Display 9
Blending Real Assets Improves Risk-Adjusted Returns…but the Best Mix of Real Assets Depends on the Desired Inflation Beta
Return/Volatility Maximizing Portfolios
1965–2009
1965–2009
0.8
100
Return/Volatility
Maximizing
Portfolios
Commodity
Stocks
0.6
Gold
Bullion
Commodity
Futures
0.4 REITs
Allocation (%)
Return/Volatility
1.0
Inflation Betas vs. Volatility-Adjusted Returns
80
60
40
0.2
20
0.0
0
–2
0
2
4
6
8
10
Asset Classes
REITs
Gold Bullion
–2
0
2
4
6
Portfolio Inflation Beta
Inflation Beta
Sectors
Commodity
Futures
Commodity
Stocks
Portfolios
Historical analysis is not a guarantee of future results. The blending of real assets does not eliminate the risk of loss in a portfolio. Commodity futures prior to 1990 are on a
US consumption–weighted basis and are sourced from the AllianceBernstein series prior to 1970 and from the MJK Commodity Futures Database between 1970 and 1990; they are
represented by DJ-UBS thereafter. Commodity-related stocks and futures are sourced from the Ken French Data Library. Gold bullion is represented by London FX, and REITs by
the NAREIT Index.
Source: BLS, Ken French, GFD, London FX, London Times, NAREIT, The New York Times, The Wall Street Journal, and AllianceBernstein
negative inflation betas (though still higher than diversified
equities). Commodity futures and precious metals, at the lower
right, provide a very pronounced response to any increase in the
rate of inflation—with historical inflation betas approaching
10—but with a much less attractive risk/return profile. In short,
for assets with higher inflation betas, you have to pay a higher
cost (in the form of lower risk-adjusted returns).
Fortunately, the risk-adjusted return for any desired inflation
beta can be improved by combining various real assets. Our
research shows that by judiciously blending these highervolatility assets in a diversified portfolio of inflation hedges, we
can moderate the fundamental trade-off and build a Real Asset
portfolio that has high inflation sensitivity, reliability, and
risk-adjusted returns. The chart on the left in Display 9 replicates
the previous display but shows the benefit of grouping the
individual hedges into their representative asset classes (the
labeled blue squares), with REITs at one end, gold at the other,
and commodity stocks and commodity futures in between.6 The
black line arching above the blue squares represents different
combinations of the four asset classes that historically maximized the risk-adjusted return for any given inflation beta.
The chart on the right in Display 9 shows the mix of assets that
underlie that black line. Going with REITs exclusively would have
delivered a high risk-adjusted return at the expense of providing
a slightly negative inflation beta. Conversely, during this period,
gold would have maximized the inflation beta but would have
led an investor to suffer rather poor risk-adjusted returns. The
highlighted segments represent the range of allocations that
cluster around the highest available risk-adjusted return, with an
inflation beta between 2 and 4.
Together, these charts show that volatility-adjusted returns for
real assets were historically maximized—and a respectable
inflation beta achieved—with portfolios falling within the
highlighted area. Our research therefore suggests that while
tactical tilts toward a specific real asset may sometimes be
Commodity stocks are weighted by market capitalization, and commodity futures are weighted by global production, according to the DJ-UBS methodology from 1990 on; prior to
1990, we use US consumption weights. All futures returns are fully collateralized by T-bills unless otherwise indicated.
6
Deflating Inflation: Redefining the Inflation-Resistant Portfolio
11
Display 10
All Inflations Are Not Equal: Global vs. Local Inflation Hedges
Real Asset Reliability Peaks with Greater Diversification
For most investors, it’s both natural and sensible to focus on the
path of inflation in one’s home country, as most of us meet the
bulk of our spending needs by purchasing goods and services
domestically. While inflationary events in developed nations are
by and large global phenomena, inflation at home is sometimes a
product of local or country-specific factors. Therefore, an asset’s
tendency to be more responsive to a domestic or a global
inflation shock is an important variable that contributes further
uncertainty regarding the performance of inflation hedges.
Real Asset Portfolio
Positive Return in Rising Inflation Years
1965–2009
Percent
85
80
75
–2
–1
0
1
2
3
4
5
6
7
8
Portfolio Inflation Beta
Historical analysis is not a guarantee of future results. Commodity futures are represented
by AllianceBernstein prior to 1970, by the MJK Commodity Futures Database
between 1970 and 1990, and by DJ-UBS thereafter; commodity-related stocks and
gold bullion by the Ken French Data Library; and REITs by the NAREIT Index.
Source: BLS, Ken French, London Times, NAREIT, The New York Times,
The Wall Street Journal, and AllianceBernstein
appropriate, a strategic Real Asset portfolio should include a
well-diversified mix of real estate equities, commodity stocks,
and commodity futures, with, possibly, a small allocation to gold.
In addition, a well-diversified Real Asset portfolio substantially
mitigates the compromise between inflation beta and
reliability. Display 10 shows the percentage of rising inflation
years since 1965 when the optimal real asset combinations
posted positive returns. Reliability peaks with precisely the
portfolios containing the most balanced blend of real assets,
with almost 85% reliability—a degree of reliability similar to
that of a Real Bond portfolio.
For example, most commodity prices respond to global supplyand-demand pressures. It follows that commodity inflation betas
relate almost entirely to changes in global, rather than domesticonly, inflation.7 When changes in the domestic inflation rate
correlate highly with changes in global inflation, commodities
can be expected to deliver their characteristically high inflation
beta. But to the extent that domestic inflation shocks are not
synchronized with the globe, commodities will perform less well
as a hedge against home-country inflation. For a stark example,
a diversified basket of global commodities hedged back to the
local currency would not have provided much of an inflation
hedge to an investor in Zimbabwe (which recently experienced
hyperinflation). Similarly, global real estate equities and commodity equities are driven primarily by global inflation and, if
fully hedged to domestic currency, can leave a portfolio
vulnerable to a domestic-only inflation shock.
By contrast, foreign currency is likely to hedge inflation best
when domestic inflation shocks deviate significantly from global
trends. Currency forwards—the returns of which are implicitly
embedded in unhedged foreign investments via short-term
interest rates—price in the expected inflation differential
between two countries. If both domestic and foreign inflation
jump by the same amount, then the forward price should not
be expected to move. But if domestic inflation surprises by more
than foreign inflation, then—all else equal—the domestic
currency will tend to weaken to maintain the relative purchasing
power of the currencies. This weakening provides investors with
positive returns to foreign currency exposure, thus serving as a
hedge against domestic inflation spikes.
This assumes commodity futures exposures are hedged into domestic currency to separate asset returns from returns associated with foreign currency exposure.
7
12
AllianceBernstein.com
Factoring In the Cost of Inflation Protection
Like most hedges, inflation protection does not come free of
charge. Although our three buckets of inflation-hedging
assets contain no greater direct costs than any traditional
portfolio—they all consist of liquid, investable assets or
investment services—they do have an implicit cost: forgone
return potential.
In the fixed income space, for example, the expected return
give-up for inflation-linked bonds relative to their nominal
counterparts can be substantial. First, because inflationprotected returns inherently have less risk, nominal bonds
should offer a risk premium to attract investors. But because
inflation-linked bonds are less liquid than their nominal
counterparts, ILBs need to offer investors a liquidity premium.
We estimate the net cost of the inflation risk premium of
nominal bonds after adjusting for the liquidity premium on ILBs
to be between 25 and 50 basis points over the long run. And in
the context of bond returns, that is a meaningful sacrifice.
Further, since most tax-exempt investors will source their ILB
allocation from their existing diversified bond portfolios rather
than from a pure government bond portfolio, an allocation to
pure government-issued ILBs would entail the forfeiture of the
additional returns and diversification benefits offered by nongovernment securities. The inflation protection offered by pure
government ILBs is therefore quite expensive for most investors. However, a Real Bond portfolio that blends the characteristics of ILBs and multi-sector bonds can greatly reduce this
opportunity cost.8
As we saw in the previous section, most investments with higher
inflation betas also have lower risk-adjusted returns. While a
diversified Real Asset portfolio of higher-risk, inflation-sensitive
assets can improve this trade-off relative to any single inflation
hedge, investors should still expect a Real Asset portfolio to forfeit
risk-adjusted return relative to a similarly volatile portfolio of
diversified equities.
One way to dimension the cost of insuring against inflation is to
compare the historical reduction in returns an investor would
have experienced between owning “traditional” versus “real”
investments. Display 11 shows the relative performance of the
(continued on page 16)
Display 11
Inflation Protection Suite Has Cost and Deflationary Downside
Relative Return of Real Investment vs. Nominal Counterpart
1909–2009
10
5
Percent
The best way to address the uncertainty around inflation betas
created by an asset’s sensitivity to global versus domestic-only
inflation is to incorporate additional exposures in the mix.
Maintaining some foreign currency exposure in a Real Asset
portfolio and collateralizing the commodity futures positions
with domestic bills or, where feasible, inflation-linked bonds
may help balance the inflation exposures of the portfolio,
bolstering the reliability of its inflation beta.
0
–5
–10
Rising Inflation
Real Cash
Normal
Real Bonds
Deflation
Real Assets
Historical analysis is not a guarantee of future results. Rising Inflation references
10-year periods when inflation was 3% (or more) higher than the prior 10 years;
Deflation includes the 10-year periods with price declines; and Normal includes all other
periods. Real Cash represents the relative return of AllianceBernstein one-year synthetic
TIPS versus T-bills; Real Bonds represents the relative return of AllianceBernstein
five-year synthetic TIPS versus five-year Treasuries; and Real Assets represents the
relative return of a real asset portfolio (comprising one-third US commodity stocks,
one-third US REITs, and one-third commodity futures fully collateralized by 10-year
TIPS) versus the S&P 500. (All futures are US consumption–weighted; commodity
stocks are market capitalization–weighted.) Commodity futures prior to 1990 are
sourced from the AllianceBernstein series prior to 1970 and from the MJK
Commodity Futures Database between 1970 and 1990; they are represented by
DJ-UBS thereafter.
Source: BLS, CRB, Ken French, GFD, London Times, The New York Times,
USDA, The Wall Street Journal, and AllianceBernstein
Another, less efficient alternative would be to alter the characteristics of the investor’s remaining investment in nominal fixed income assets to compensate for the increased exposure to
the government sector coming from ILBs.
8
Deflating Inflation: Redefining the Inflation-Resistant Portfolio
13
Back to the Futures: A Long-Term History of Commodity Returns
The long-cycle nature of commodity fundamentals combined with the short history of commodity futures prices
makes empirical analysis of these instruments difficult.
Published commodity futures data go back to the 1970s,
and since that time we have witnessed only two major
commodity cycles, one global inflation cycle, and no global
deflation cycles. Basing strategic allocation decisions on such
limited history struck us as imprudent, so we built a
proprietary database of US and UK commodity futures
returns and commodity inventories* extending back to the
1890s. What we found reaffirmed some of the positive
attributes of commodity futures but also suggested caution
in extrapolating historical commodity performance.
Published spot commodity prices date back at least to the
1800s and confirm that on average, commodity prices
Spot Commodity Returns Have Been In Line with Inflation
Real Spot Returns (Annualized)
1900–2009
2
appreciate in line with broad inflation measures, as shown in
the display to the left below. Futures returns, however,
incorporate an additional source of risk and return in the
form of “roll return”: the difference between the spot price
and futures price of a commodity at any point in time. This
roll return turns out to be a major driver of commodity
futures returns. As demonstrated in the display to the right
below, commodity futures with higher roll return (like
gasoline) also have higher futures returns.
For a US consumption-weighted basket of commodity
futures, roll return contributed 2% per year to returns from
1900 through 2009, according to our estimates. The spot
and roll returns for commodities also responded well to the
World War I and World War II inflation cycles, just as they
did in the 1970s cycle. (See the Appendix, pages 33–35,
for more information.) These positive findings, however,
were counterbalanced by some cautionary notes: Commodities can cease trading or their value may be manipulated by government interference.
Roll Return Tends to Drive Futures Returns
1
Futures Excess Returns vs. Roll Return (Annualized)
0
–1
20
Average: –2 b.p.
Coffee
Sugar
Cotton
Corn
Oats
Wheat
Lead
Tin
Copper
Zinc
Nickel
Aluminum
Platinum
Gold
Silver
Coal
Crude
–2
Historical analysis is not a guarantee of future results. Agricultural commodities are
sourced from CRB, IMF, NBER, and USDA; energy by CRB, Energy
Information Administration (EIA), IMF, and NBER; and metals by CRB, IMF,
NBER, and USGS.
Source: BLS, CRB, DJ-UBS, EIA, Federal Reserve (Philadelphia and St.
Louis), IMF, London Times, MJK Associates, NBER, The New York
Times, USDA, USGS, The Wall Street Journal, and AllianceBernstein
Futures Returns (%)
Percent
1900–2009†
Gasoline
10
0
–10
–20
Eggs
–10
0
10
20
Roll Return (%)
†Or life of contract
Source: London Times, MJK Associates, The New York Times, The Wall
Street Journal, and AllianceBernstein
*Historical analysis is not a guarantee of future results. We collected inventory data in order to empirically test the theory that inventory dynamics are an important driver
of commodity futures returns.
14
AllianceBernstein.com
Because commodity futures returns depend in large part on
roll returns, any structural decline in the relationship
between spot and futures prices is a cause for concern. In
the historical record, eight major commodity futures‡ ceased
active trading after structural shifts reduced the risk of
stockouts and hence the need for a risk premium provided
by roll return. Lard demand, for example, terminally
declined following the adoption of vegetable oils during
World War II. Similarly, egg supplies became more reliable
following World War II, when technology made year-round
production possible. On average, these deceased contracts
underperformed their contemporaries by a roll-induced 500
basis points per year over their lives, as seen in the display
to the right.
Could a structural change impact the required risk premium
of a major commodity today? Natural gas—which is the
second-largest weighting (over 10%) in the Dow Jones-UBS
Commodity IndexSM—faces a number of potential structural
challenges to its supply-demand dynamics. Thanks to liquid
natural gas and the broad implementation of “hydraulic
fracturing” drilling technologies, recent estimates put
supply at levels sufficient for at least another 100 years,
contributing to record-low roll returns. More disconcerting,
however, is the possibility that passive, long-only investment
flows into commodity futures over the past couple of years
have permanently lowered the risk premium required across
all commodity futures. In particular, the longer-term
behavior of roll return in relation to inventories suggests
that the risk premium embedded in energy futures has
fundamentally diminished. Due to this prospective decline
in roll return, we have reduced the historical return from roll
by 200 basis points in all of our analyses.
Commodity Futures Risk Catastrophic Underperformance
Relative Performance of Discontinued Futures Contracts
Life of Contract vs. Contemporaries (1900–2009, Annualized)
6.1
Percent
Survivorship Bias:
When a Commodity No Longer Trades
–12.9
–6.9
–6.6
Rye
Lard
–3.8
–2.8
–1.4
Average: –5.0
–11.7
Eggs Potatoes
Wool Cottonseed Hides Rubber
Oil
Historical analysis is not a guarantee of future results.
Source: MJK Associates, The New York Times, The Wall Street Journal,
and AllianceBernstein
Government Interference
The longer historical record highlights another cause for
concern: Commodity investors have often had to contend
with government interference during times of sharply
rising prices. In both the World War I and World War II
commodity booms, the US government implemented price
controls that essentially halted trading for most commodity
futures. Interestingly, while the controls always took the
form of price ceilings for imported commodities such as
sugar, they occasionally took the form of price floors for
domestically produced commodities such as wheat. The
political rhetoric directed at oil “speculators” since 2008,
when the price of (mostly imported) crude hit $140 a barrel,
suggests that the risk of political interference remains alive
and well. Clearly, the potential for such untimely interference reduces the reliability of commodity futures as an
inflation hedge. n
‡Cottonseed oil: 1917–1967; eggs: 1950–1980; hides: 1932–1967; lard: 1900–1962; potatoes: 1950–1987; rubber: 1929–1965; rye: 1922–1970; wool:
1944–1974
Deflating Inflation: Redefining the Inflation-Resistant Portfolio
15
(continued from page 13)
different hypothetical inflation-hedging portfolios compared
with their traditional counterparts over time. While on average
each category of inflation protection would have outperformed
during episodes of rising inflation, each would likewise have
detracted from performance in normal times (i.e., periods
characterized by low or declining inflation). And “normal,” by
definition, means most of the time, so this could add up to a
significant cost over long time horizons. And as the set of bars
on the right shows, this protection comes with a potential
21%
downside: In a deflationary environment, inflation hedges
can
16%
detract significantly from a portfolio’s overall return.
21%
however, are fully subject to federal taxes, which can make an ILB
allocation cost-prohibitive to a taxable investor.9 Fortunately, by
overlaying a municipal bond portfolio with “inflation swaps,”
taxable US investors can obtain the inflation sensitivity of TIPS with
tax efficiency approaching that of traditional municipals.10
Taxable investors also face tax costs when investing in Real
Assets. Most forms of commercial and multifamily real estate,
for example, throw off large amounts of potentially taxable
17%
100%
17%
100%17%
100%
income. Similarly, in the US, commodity futures face 60%
21%
21%
and 40%
short-term
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17%long-term
100%
17%
100%
17%tax treatment
100% on
16%
any realized
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21%gain. And16%
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16%
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faces
37% the possibility of 37%
37%the full brunt of these taxes, then the inflation
16%
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21%warrant the
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9%
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16%
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16%
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Inflation-Hedging Scorecard:
Which Assets Have Which Strengths
Display 12 provides a summary of the inflation sensitivity,
reliability, and cost-effectiveness of the major prospective
inflation hedges.
In the Real Cash category, short-term inflation-linked bonds
provide extremely high reliability and cost-effectiveness, with
modest inflation sensitivity. The same is true for intermediate- to
longer-term ILBs in the Real Bonds category.
Among higher-risk, higher-return real investments, several
themes emerge. Commodity futures and gold have the
strongest inflation beta, but they come up short on reliability.
Also, they carry substantial opportunity costs; gold in particular
has exhibited returns over the long term in line with inflation
itself, meaning its real returns have been near zero over time.
Real estate equities and commodity stocks sacrifice less return
relative to their traditional counterparts—in this case, diversified
equities—and score fairly well in terms of reliability. Finally,
farmland and timber have attractive sensitivity and reliability,
but they are somewhat less cost-effective and less liquid. A Real
Asset portfolio with a diversified mix of commodity futures and
commodity and real estate stocks, as well as foreign exchange
exposure (to protect against the threat of a domestic-only versus
global inflation shock) and perhaps a small amount of gold,
provides a far better balance of sensitivity, reliability, and
cost-effectiveness than any of the individual components alone.
So far, we’ve shown which investments should provide the best
protection against inflation and illustrated some of their other
characteristics. Now it’s time to ask how much and what type
of inflation protection investors should have, and how the
inflation hedges assessed here may be best incorporated into
their portfolios. n
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Chapter Highlights
n
Three key factors determine the effectiveness of an inflation hedge: inflation sensitivity, reliability, and cost-effectiveness.
n
Investors can take advantage of less risky inflation hedges to create Real Cash and Real Bond portfolios.
n
Investors may overcome some of the shortcomings of riskier inflation hedges by combining them into a
Real Asset portfolio.
n
The cost of inflation protection consists of the expected return give-up versus traditional investments.
Deflating Inflation: Redefining the Inflation-Resistant Portfolio
17
Getting Real
Incorporating Inflation Protection in the Portfolio
Given the trade-offs inherent in the sensitivity, reliability, and
cost-effectiveness of inflation hedges, the amount and type of
inflation protection investors choose will differ according to
each investor’s unique situation and preferences.
In the previous chapter we showed that inflation hedges fall
into three basic categories: Real Cash, Real Bonds, and Real
Assets. As the left side of Display 13 illustrates, each component
of this suite of real investments plays a role in the landscape of
expected risk and return. Thus, investors can incorporate these
inflation hedges in their portfolios in accordance with their
existing risk and return goals, similar to the way regular cash,
bonds, and stocks form the building blocks of their traditional
asset allocations.
be prepared to sacrifice in order to hedge their inflation-related
vulnerability, and the more inflation protection they will want
to incorporate in their portfolios (Display 13, right). Inflation
vulnerability is largely a function of how “real” the investor’s
liabilities are expected to be. Some liabilities are fixed in
nominal terms, such as fixed-rate mortgage payments for an
individual, but many liabilities are exposed to inflation risk.
Inflation linkages can be explicit, such as the inflation-indexed
benefits associated with some pension funds. However,
liabilities can also have implicit inflation sensitivity, such as the
future budget expenditures of a foundation or the lifestyle
spending needs of an individual. In sum, the more an investor’s
liabilities rise with inflation, the greater the exposure to an
inflation shock, and the more protection will likely be needed.
When building any asset allocation, risk tolerance drives the
mix of asset classes. This is also true of real investments: The
lower their appetite for risk, the more return investors would
However, investors’ vulnerability to inflation doesn’t end with
their liabilities: A true measure of that vulnerability is driven by
their holistic balance sheets. We noted above that many
Display 13
Key Decisions for Buyers of Inflation Protection
How Much?
What Type?
More
Real
Real Bonds
More
Nominal
Real Cash
More
Protection
Liabilities
Expected Return
Real Assets
Less
Protection
Higher
Risk
Source: AllianceBernstein
18
AllianceBernstein.com
Lower
Risk Tolerance
Display 14
Investor Balance Sheet Incorporates Inflation-Sensitive
Income Assets and Liabilities
Holistic Investor Balance Sheet
Individual
 Investment Portfolio
 Cash Reserves
Financial
Assets
Institutional
 Defined-Benefit Plan
 Endowment Fund
Individual
 Human Capital
Institutional
 Sponsor Contributions
 Fund-Raising Ability
Income
Assets
Assets
Individual
 Lifestyle Spending
 Bequest Goals
 Mortgage Payments
Institutional
 Benefit Obligations
 Budget Expenditures
 Debt Payments
Liabilities
For illustrative purposes only
Source: AllianceBernstein
investors will have liabilities explicitly linked to inflation. But an
investor’s balance sheet also includes assets that are likewise
impacted by a rise in inflation. As the left-hand column of
Display 14 shows, a holistic view of any investor’s assets should
include both traditional financial assets (such as stocks, bonds,
and cash in an investment portfolio) and income-related or
nonfinancial assets (such as an individual’s future wages or an
endowment’s fund-raising potential). Income-related assets
often benefit from rising inflation, so they are a key consideration in the inflation-hedging decision. Because income-related
assets tend to provide a natural inflation hedge, investors with
fewer such assets will generally need more inflation protection
in their “financial asset” portfolio.
Ideally, an investor’s assets and liabilities would have offsetting
inflation sensitivities, but most do not match up precisely. Some
mismatches are good: For example, individuals with assets that
significantly exceed their anticipated spending needs have
“excess capital.” Such investors may be able to effectively
self-insure—meaning that their excess capital serves as a
cushion for the damage inflation might cause. By contrast,
investors who have more inflation-linked liabilities than assets
will need more inflation protection. It’s the net asset–to-liability
mismatch that is the key factor in this analysis.
Our approach to the inflation protection decision has clear
parallels with liability-driven investing (LDI).11 In essence, LDI
focuses on optimizing the risk/return trade-off of one’s net worth,
since an asset portfolio that is poorly matched to the investor’s
liabilities is itself a source of risk that should be managed. We can
use our asset allocation tools to assess this trade-off and derive
sensible allocations for a variety of investor types.
How Much Inflation Protection Is Appropriate?
Display 15, following page, summarizes our recommendations
for a number of representative investors, including individuals,
endowments and foundations, and pension plans of various
stripes. The key variable driving the range of recommendations
for each investor type is risk tolerance. The white squares show
the recommended real investment allocation for investors with
an average tolerance for risk. The tops of the bars reflect the
typical recommendation for investors with higher risk aversion
(and, correspondingly, lower return requirements), while the
bottoms of the bars indicate the inflation protection exposure
for investors who have a relatively high tolerance for risk.
For individual investors, the average allocation to inflation
protection rises as the individual ages: 10% for those who are
of working age; 20% for those at retirement; and, finally, 40%
for investors in late retirement. This increase reflects the
diminishing amount of future income remaining as individuals
move through their life cycle. However, individuals with
significant capital in excess of their lifetime spending needs have
a cushion that reduces the need for inflation hedges. We
recommend that such investors allocate about 15% to various
forms of real investments, regardless of their age.
Endowments and foundations vary in their recommended
inflation protection allocations as well. High spending needs
(and, correspondingly, high return needs) lead both foundations
and endowments to take on less inflation protection than might
otherwise be expected given the highly inflation-sensitive nature
of their liabilities; we recommend approximately 20% for the
See William F. Sharpe and Lawrence G. Tint, “Liabilities—A New Approach,” The Journal of Portfolio Management (Winter 1990), for a technical overview of related
surplus optimization techniques.
11
Deflating Inflation: Redefining the Inflation-Resistant Portfolio
19
Display 15
Inflation Protection Allocation Varies by Investor Type and Risk Tolerance
Real Investment Allocation Ranges
By Investor Type and Risk Tolerance
Inflation Protection Allocation (%)
Individual Investors
Endowments and Foundations
Pension Plans
60
Risk
Averse
40
20
Risk
Tolerant
0
Working
Age
At
Late
Retirement Retirement
Investor
with
Excess
Capital
More Inflation Protection…
…as investor ages
…as excess capital diminishes
Endowment Foundation
More Inflation Protection…
…as % of income assets falls
…as return objectives decline
Pension
(No Benefits
Indexation)
Pension
(Benefits
Indexed to
Inflation)
More Inflation Protection…
…as % of real liabilities increases
…as funding ratio declines
These ranges are for illustrative purposes only and are meant as a guide. Asset allocation percentages will change based on individuals’ circumstances.
Source: AllianceBernstein
average foundation and about 15% for the average endowment. Differences between the two are largely attributable to
the availability of income-related assets. Foundations tend to
have relatively low income assets as a percentage of total assets,
whereas endowments need less inflation protection because
their inflation-linked contributions provide a meaningful hedge.
How much protection pension plans need is heavily dependent
on whether or not the majority of benefit obligations are
indexed to inflation. Plans with no benefits indexation may
require less than 10% exposure to inflation hedges, while plans
with indexed benefits have significant inflation-related liabilities
and thus need more inflation protection; we recommend an
allocation, on average, of about 30% to inflation protection for
indexed plans. What’s more, as we will discuss in detail below,
inflation-indexed plans are further differentiated by funding
ratio, with overfunded plans requiring somewhat less protection and underfunded plans somewhat more, holding risk
appetite the same.
20
AllianceBernstein.com
Note that despite our assumption that most of these representative investors face mainly real liabilities (pension plans without
indexed benefits are the primary exception), we don’t recommend that any of them—even those with above-average risk
aversion—pursue an allocation to inflation hedges much above
50% of their investment portfolio. The reason for this is that
investors’ risk tolerance—implicit in their existing asset allocation
and reflective of their return requirements—plays a large part in
how much return they are willing to sacrifice in order to minimize
their asset-liability mismatch. In theory, extremely risk-averse
investors would simply replace traditional assets with real
investments until their assets—including any nonfinancial or
income assets—achieve the best possible counterweight or hedge
against the risks they face on the liability side of the ledger. In
practice, for most investors this is simply too costly a commitment. As such, more risk-tolerant investors will generally hedge
less, opting to accept the risks of a mismatch between their
assets and liabilities rather than forgo the potential for higher
70
70
60
60
50
50
40
40
30
30
20
20
10
10
0
0
Pension E
(No Benefi
INdexation
0
0
0
0
0
0
0
Endowment
fits
n)
Display 16
Real Investment Mix Varies with Risk Tolerance
Real Investment Mix
For At-Retirement Individuals*
What Type of Inflation Protection Is Appropriate?
Beyond playing a crucial role in determining the amount of
inflation protection that is appropriate for a given investor, risk
tolerance also weighs heavily in determining what type of
protection—in other words, what mix of Real Cash, Real Bonds,
and Real Assets—makes sense.
More risk-averse investors will seek to hedge their liabilities with
less regard for cost. This implies not only a higher allocation to
inflation protection but also a desire to improve the accuracy of
the asset-liability match by incorporating financial assets that
Pension
Foundationtheir liabilities. Because many investors’ real
closely
resemble
(Benefits
liabilities
Indexed toare most similar to inflation-linked bonds (their spending
Inflation)
tends
to rise with the domestic inflation index, like the cash flows
of ILBs), Real Bonds should tend to dominate in risk-averse
portfolios.13 However, more risk-tolerant investors will be less
willing to give up return (by sourcing an allocation to inflationlinked bonds from their higher-returning assets) in an attempt to
match assets and liabilities. At higher levels of risk tolerance, only
Real Assets provide enough diversification benefit and inflationhedging “bang for the buck” to justify an allocation.
Display 16 brings this dynamic to life, showing how the allocation
to Real Cash, Real Bonds, and Real Assets varies according to risk
tolerance. Not surprisingly, the most cautious investor in this
example, indicated by the bar on the left, has a small portion of
assets in Real Cash, about 26% in Real Bonds, and almost 9% in
Real Assets (in other words, almost all of the inflation protection
consists of inflation-linked bonds). By contrast, the most aggressive investor, at the far right, may hold all of the inflation protection in Real Assets, accounting for just 10% of the investment
portfolio. Investors with “normal” risk appetites fall in the middle.
Here, the moderate-risk investor (originally allocated approximately
40
Inflation Protection Allocation (%)
0
returns.12 Practically speaking, this means that for many investors,
the total allocation to inflation protection should be fairly
small—even for those with a moderate aversion to risk.
30
20
10
0
Low Risk
Moderate Risk
High Risk
Risk Profile
Real Cash
Real Bonds
Real Assets
These ranges are for illustrative purposes only and are meant as a guide. Asset allocation
percentages will change based on individuals’ circumstances.
*Assumes income assets and liabilities are real and that the investor is fully funded (i.e.,
no excess capital). Low Risk, Moderate Risk, and High Risk categories approximate
equity-like risk exposures of 40%, 60%, and 80%, respectively, in this example.
Source: AllianceBernstein
60/40 to equity-like and bond-like investments, respectively) might
opt to reallocate the portfolio to include approximately 10%
exposure each to Real Bonds and Real Assets.14
Thus far we’ve addressed the role of risk tolerance in establishing both the range of allocations to inflation protection and the
proportions of the various inflation-hedging asset categories
(Real Cash, Real Bonds, and Real Assets) appropriate for a given
investor type. We have also briefly described why our recommended allocation to inflation protection should vary within and
across investor types. In the next section, we will look more
deeply at the drivers that further differentiate these investors
and influence their appetite for inflation-hedging assets.
In the extreme, highly risk-tolerant investors with inflation-sensitive assets and largely nominal liabilities may want to short inflation protection. A drop in inflation will lower the
value of their assets and raise the value of the liabilities; they can get paid to offset this risk by shorting real investments.
13Investor liabilities are “similar” to a portfolio of inflation-protected bonds only in terms of certain shared factors, such as those that can explain changes in cash flows or returns over
time. Any given investor’s liabilities will also include a substantial idiosyncratic risk component that can be difficult if not impossible to hedge effectively. Although this does not alter
the hedging decision, it does create “basis risk” between inflation-protected bonds and an investor’s particular liabilities. In this sense, even a “full hedge” may still fall short of a
“perfect hedge.”
14As we assume throughout, this hypothetical 60/40 characterization does not imply an actual allocation to only stocks and bonds. Rather, it is cited as a proxy for exposures to
asset classes that have similar risk profiles. For example, private equity, hedge funds, and illiquid real assets such as real estate and timber would all be counted as equity.
12
Deflating Inflation: Redefining the Inflation-Resistant Portfolio
21
Inflation Protection for Individual Investors
Consider, first, the case of typical individual investors with a
moderate risk tolerance as they progress through life. As
younger individuals with significant remaining lifetime earning
potential, they can reasonably expect their earnings to keep
pace with inflation over time. Early in life, the size of their
income-related assets as a percentage of their total assets can
therefore be quite large. As they age and most of their working
years are behind them, the relative size of this “human capital”
shrinks—and with it a valuable inflation hedge. Some of this loss
is taken up by increases in the value of expected Social Security
income and, in the case of homeowners, the value of home
equity—both of which we classify as inflation-linked assets. On
the whole, however, nonfinancial assets typically fall over time as
a percentage of an individual’s total assets.
As Display 17 illustrates, these dynamics suggest that the
allocation to inflation-hedging assets will tend to follow a “glide
path” for most individual investors, with inflation hedges playing a
small but growing role as the typical individual investor ages. The
rising green line shows the appropriate level of inflation protection
in a portfolio based upon investor age or, more accurately, the
investor’s stage in the investing life cycle. The points labeled
Display 17
Inflation Protection for a Typical Individual Investor
Should Rise over the Investor’s Life Cycle
Allocation to Real Investments
Inflation Protection Allocation (%)
By Life-Cycle Stage*
50
Late Retirement
40
30
At Retirement
20
Working Age
10
0
Working
Years
Life-Cycle Stage
Retirement
Years
These ranges are for illustrative purposes only and are meant as a guide. Asset allocation
percentages will change based on individuals’ circumstances.
*Assumes income assets and liabilities are real and that the investor is fully funded (i.e.,
no excess capital)
Source: AllianceBernstein
22
AllianceBernstein.com
“Working Age,” “At Retirement,” and “Late Retirement” reflect
the individual investor shown in Display 15 (page 20), indicating
average allocations of about 10%, 20%, and 40%, respectively.
Here, we’ve shaded the area representing the investor’s
retirement years to highlight an important consideration. During
retirement, investors draw from their investment portfolios at
different rates, thus creating the potential for marked variation
across retirees in the role played by outside real income assets.
For example, investors drawing down their financial assets at a
significant rate (and thus increasing the relative size of the
inflation-indexed Social Security income assets in their holistic
balance sheet) generally should demand less inflation protection, perhaps even falling closer to the “At Retirement”
allocation than the “Late Retirement” recommendation.
While the life-cycle drivers above make eminent sense from the
perspective of an average investor, for investors with capital in
excess of what is required to support their spending needs, a
separate set of drivers is likely to determine the appetite for inflation protection. By definition, they have substantial financial
assets, so their nonfinancial assets (including Social Security, for
example) are a relatively low percentage of the total. This might
indicate a need for inflation protection similar to that of retired
individuals, whose portfolio wealth also dominates the asset side
of their personal balance sheets. What separates the two,
however, is that many of these investors spend far less than what
their assets could reliably support. In other words, whereas typical
investors have only core capital (meaning they effectively rely on
every investment dollar they have to support their core spending
needs), some investors may have significant excess capital.
Display 18 explores the impact of varying amounts of excess
capital on the inflation protection allocation of an individual
investor with a moderate risk tolerance. Note the effect of
higher levels of excess capital on both the amount and composition of inflation protection. Investors with little excess capital
demand more than twice as much inflation protection (with an
increasing portion coming from Real Bonds) than their more
“self-insured” peers at the opposite end of the spectrum. The
reason is that excess capital provides a valuable cushion against
Display 18
Excess Capital Reduces the Need for Inflation Protection
Allocation to Real Investments
Inflation Protection Allocation (%)
For Individuals with Moderate Risk Tolerance*
20
7%
15
10
5
0
Core
Capital
Excess Capital
Real Bonds
High
Excess
Real Assets
These ranges are for illustrative purposes only and are meant as a guide. Asset allocation
percentages will change based on individuals’ circumstances.
*Assumes income assets and liabilities are real. Moderate Risk approximates equity-like
risk exposure of 60% in this example.
Source: AllianceBernstein
the adverse impact of an inflation shock on one’s net worth,
while the vanishingly small margin between assets and liabilities
in the case of the core-only investor results in significant
net-worth volatility if steps are not taken to hedge this risk. A
final consideration of particular importance for all individual
investors involves the tax efficiency of inflation hedges. Here,
we’ve assumed inflation protection can be sourced without
undue tax consequences vis-à-vis existing asset classes.15 As
mentioned in the prior chapter, to the extent this is not possible,
the inflation protection should be curtailed or, in some cases,
forgone altogether.
Inflation Protection for Institutional Investors
Like individuals, institutional investors vary widely in their risk
tolerances, exposure to inflation-linked liabilities, and broader
portfolio objectives and constraints. Endowments and foundations, in particular, provide an interesting comparison and a
meaningful departure from the individual-investor advice
explored above.
Endowments and foundations both face predominantly real
liabilities and generally aspire to fund a stream of inflationlinked cash flows, whether mandatory or discretionary. And
their financial assets tend to represent the bulk of total assets,
like a post-retirement individual. However, whereas individuals
typically expect to draw down their investment portfolios to
support spending throughout retirement, foundations and
endowments generally aim to preserve the purchasing power of
their portfolios over time, even after meeting their payout
obligations. With spending rates often around 5% annually,
maintaining the real value of the portfolio implies the need for
relatively high portfolio returns. As such, these funds should be
expected to have a below-average willingness to match their
liabilities at the expense of higher expected returns and,
correspondingly, a lower allocation to inflation protection than
their liability exposures might suggest. Again, referring back to
our summary recommendations in Display 15 (page 20), this
equates to average endowment and foundation inflation
protection allocations of about 15% and 20%, respectively.
Endowments tend to differ from foundations when it comes to
outside, income-related assets: The holistic balance sheet of
endowments is likely to include a relatively larger proportion of
real income assets—in the form of future gifts and contributions—whereas foundations often have limited assets beyond
the investment portfolio. This supports our recommendation
that foundations, in general, are likely to require more inflation
protection than endowments.
Pension plans present yet another set of investor-specific
concerns. Pension funds with a modest risk profile will generally
hold a portfolio of assets with risk akin to a 60% stock/
40% bond portfolio and generally share an above-average
sensitivity to any asset-liability mismatch. However, these funds
can differ significantly from one another in their funding ratios
and in their exposure to real liabilities. The line slanting upward
from left to right in Display 19, following page, illustrates the
levels of inflation protection that may be optimal for pension
plans with inflation-indexed benefits at a variety of funding ratios,
going from overfunded on the left to underfunded on the right.
In terms of practical implementation, this might require that Real Bonds be taken in the form of municipal bonds overlaid with inflation swaps in a taxable account and/or Real
Assets being restricted to tax-deferred accounts.
15
Deflating Inflation: Redefining the Inflation-Resistant Portfolio
23
Display 19
Pension Plan Inflation Protection Varies by Funding Ratio and
Exposure to Real Liabilities
Allocation to Real Investments
For Pension Plans with Moderate Risk Tolerance*
Inflation Protection Allocation (%)
50
Real Returns*
Benefits
Indexed
40 Rolling 10-Year Inflation and Negative 60/40
to Inflation
30
20
No Benefits
Indexation
10
0
Overfunded
Underfunded
Funding Ratio
These ranges are for illustrative purposes only and are meant as a guide. Asset allocation
percentages will change based on individuals’ circumstances.
*Assumes income assets are real and that liabilities are 100% real (Benefits Indexation)
or 50% real (No Benefits Indexation). Moderate Risk approximates equity-like risk
exposure of 60% in this example.
Source: AllianceBernstein
While significant inflation indexation is rare in the US, where
pension benefits are more typically fixed in nominal terms, it is
more common in the UK, where indexation of pension obligations is the norm. The blue line at the bottom shows the
inflation protection allocation of an otherwise identical plan
without inflation-indexed benefits.16 Our research suggests
that pension plans that do not face inflation indexation may
ultimately require only modest inflation protection, regardless
of their funding ratio.
Readers may be surprised to see that the allocation to lowerreturning inflation hedges in the display increases as plans become
more underfunded. Some plan fiduciaries might ask: If we’re
underfunded, why take on a greater allocation to assets with
lower returns? Don’t we need higher returns to make up for lost
ground? And for plans with any nominal liabilities, an increase in
inflation expectations (and with it an increase in interest rates) will
decrease the overall value of their liabilities, which sounds like a
benefit rather than a risk—and they might ask: Why do we need
any inflation protection at all?
The answer to both questions centers on our assumption that
investors seek to mitigate fluctuations in net worth. Even if rising
inflation reduces the value of a fund’s liabilities, it may also have a
disproportionate, adverse impact on the fund’s asset value, thus
creating undesirable volatility in the funding ratio. Similarly, when
net worth declines or turns negative, even small mismatches
between a fund’s assets and liabilities can increase risk. All in all,
inflation hedges help to provide a better asset-liability match.
That said, many investors who are underfunded opt instead to
pursue higher-returning “nominal” investments. In our view, such
a decision is reasonable for plans with higher risk tolerance,
which have correspondingly lower appetites for inflation
protection and a higher willingness to accept surplus volatility.17
When Sourcing Becomes an Issue
In practice, some investors may face constraints on how they
can source their inflation protection. For example, the bond
market in some countries may lack inflation-linked bonds, or
investment policy may preclude allocation to commodities or
other real assets. In such cases investors should generally take
more of whatever form of inflation protection is available—but
only up to a point.
For example, our moderate-risk ”At Retirement” investors in
Display 16 (page 21) could conceivably take all of their desired
inflation protection in the form of inflation-linked bonds.
However, achieving a level of inflation sensitivity similar to what
we recommend (10% in Real Bonds and 10% in Real Assets)
would actually require them to allocate about 40% to Real
Bonds—a complete reallocation of their fixed income exposure to
Real Bonds. Few investors would be willing to take such extreme
measures for the sake of inflation protection, and most would
likely choose to hedge less.
It’s important to note that the assumption of no benefits indexation does not imply insulation from inflation risk. Indeed, unless a plan is frozen and is obligated to pay only
nominal benefits, inflation risk can still enter the picture via participant salaries, which can be expected to be highly correlated with inflation over time.
17Relying on sponsor contributions to cure underfunded status is another option for “at-risk” funds. In our framework, sponsor contributions are an income asset (likely one with
“real” characteristics). This should likewise reduce the appetite for taking on inflation protection in the investment portfolio.
16
24
AllianceBernstein.com
Does It Really Make a Difference?
In conclusion, it may seem that typical allocations to inflation
protection of 10%–30% of an investment portfolio are unlikely
to provide much protection in the event of an inflationary spike.
After all, with 70%–90% of the portfolio still invested in
vulnerable stocks and traditional bonds, can real investments
have anything more than a marginal impact on wealth outcomes? As it turns out, even modest exposures to real investments may have a significant portfolio impact.
Display 20 considers three hypothetical US-based investors who
share the same risk tolerance, an initial $3 million portfolio value,
and real spending equal to 4% of beginning value. The time
period under consideration covers 10 of the most difficult years
during the so-called Great Inflation of the 1970s. The gray line at
the bottom of the display illustrates changes in the portfolio value
of an investor in a traditional 60/40 stock/bond portfolio. The
green line shows results for a hypothetical investor opting to
allocate 10% from stocks to Real Assets, while the blue line
reflects a portfolio allocating an additional 10% of the investor’s
Display 20
Exposure to Real Assets Improves Outcomes During
Inflationary Spikes
Impact on Portfolio Value at 4% Real Spending Rate*
4.0
Portfolio Value ($ Millions)
An additional constraint on sourcing arises when an investor has
an existing allocation to real investments in suboptimal proportions that cannot be easily changed. For example, an investor may
have a large illiquid allocation to a real investment such as timber
or direct real estate, when ideally he would have a balanced blend
of Real Bonds and Real Assets. In such a situation, to the extent
the existing allocation provides insufficient inflation protection, any
incremental protection should come exclusively from Real Bonds
and, possibly, from Real Cash. Again, the allocation decision will
depend on the investor’s broader objectives and constraints.
50% Stocks
30% Bonds
10% Real Bonds
10% Real Assets
3.5
$3.4 Million
50% Stocks
40% Bonds
10% Real Assets
3.0
$3.1 Million
2.5
60% Stocks
40% Bonds
2.0
$2.7 Million
1972
1973
1975
1977
1979
1981
This is a hypothetical example and is not representative of any AllianceBernstein
product. Individuals cannot invest directly in an index.
10-year period, January 1972 through December 1981
*Assumes a hypothetical nontaxable client with real spending of 4% on initial
$3 million portfolio
Source: Federal Reserve, Ken French, GFD, MJK Associates, NAREIT, and
AllianceBernstein
fixed income allocation to inflation-protected bonds. Over this
trying period the “high-protection” investor ends up with a
portfolio worth almost 30% more than the similarly volatile
traditional portfolio—and this is, again, after supporting a
fast-growing stream of cash outlays.
Clearly, the differences in wealth are material. In a twist of the
old saying, it appears that with inflation, an ounce of protection
is worth a pound of cure. n
Chapter Highlights
n
Determining the right amount of inflation protection depends on the investor’s tolerance for risk and vulnerability to
an inflation shock.
n
The greater an investor’s reliance on the investment portfolio to hedge inflation risk and the lower the investor’s risk
tolerance, the larger the allocation to inflation-hedging assets.
n
Replacing traditional assets (cash, bonds, and equities) with similar inflation-hedging assets (Real Cash, Real Bonds,
and Real Assets) minimizes distortion to the portfolio and to its risk and return objectives.
Deflating Inflation: Redefining the Inflation-Resistant Portfolio
25
Monitoring the Temperature of Inflation
When to Implement a Protection Strategy
As we’ve noted repeatedly, investors should not evaluate
inflation protection the way they do typical investment opportunities. Inflation protection is best understood as a hedge against
the potential calamity of an unforeseen acceleration in the
inflation rate. The best outcome with such a transaction is to
pay the cost and never have to experience the disaster scenario
you’re hedging against. After all, homeowners buy fire insurance hoping that a fire never occurs; the premium is an
acceptable expense to buy peace of mind.
change in inflation was high (the 1970s and early 1980s), the
difference between expected and actual inflation widened
dramatically, as forecasters continued to project the prior year’s
experience into the future (Display 21). The degree of anchoring
varies over time and across countries. The more credible a
country’s monetary policy, the less sensitive expectations will be
to recent inflation. But this backward-looking bias inherent in
inflation expectations means that significant changes in inflation
almost always come as a surprise.
Two aspects of inflation make inflation protection appealing.
The first, as seen in Display 1 (page 2), is how destructive
inflation can be to traditional investments—it can be a portfolio’s Achilles’ heel. But perhaps equally important is how difficult
it is to anticipate. We can be reasonably sure that a spike in
inflation will eventually recur—we just can’t say when. If one
can’t predict when a disaster will occur, insuring against it is all
the more important.
The insidious tendency of inflation to surprise is exacerbated by
the irony that the initial effects of inflation are often pleasurable: People and firms believe their incomes have actually risen.
They suffer from “money illusion”—the mirage that higher
Display 21
Changes in Inflation Are Mostly Unexpected
Actual Inflation less Forecasted Inflation
10
A Danger Foreseen Is More Likely Forestalled
As with just about any forecast, forward-looking expectations
about inflation tend to be grounded in the rearview mirror. They
look back at the level of actual inflation over both recent and
more distant periods, thereby “anchoring” forward estimates in
the past. For example, in periods when the year-over-year
26
AllianceBernstein.com
8
6
Percent
But just how difficult is it to time a future bout of inflation? As it
happens, armies of analysts and forecasters study every possible
marker to predict inflation, generally with little success. The
market itself—often the best “forecaster” available—constantly
provides expectations about inflation. But there’s an interesting
thing about inflation expectations: The market has been as bad
as analysts at forecasting inflation.
Actual > Forecast
4
2
0
–2
Actual < Forecast
–4
50
60
70
80
90
Historical analysis is not a guarantee of future results.
Through December 31, 2009
Source: BLS, Philadelphia Federal Reserve, and AllianceBernstein
00
10
wages, salaries, and profits signify real gains in purchasing
power. By the time they awaken to reality, inflation has secured
such a strong hold in wage and price behavior that it can be
reversed only with difficulty.
surveyed economists since 1980. Indeed, the range of inflation
estimates is now wider than it has been at any point since the
early 1980s, when the US last experienced a seismic shift in its
monetary policy regime.
Inflation Uncertainty Is Especially High Now
What’s our view on the prospects for an inflationary episode?
Let’s consider the monetary argument first. While it is true that
persistently rising inflation cannot occur without increasing the
money supply, “money printing” by the central bank does not
necessarily drive inflation up. While central banks directly
control base money supply (reserves that enable banks to lend),
they do not control the broader measures of money (actual
lending by banks and other credit channels to businesses and
individuals). And it is the broader measures of money that tend
to drive inflation. While base money creation in excess of
underlying real economic growth may lead to inflation, history
also shows that such an outcome is in no way guaranteed.
In “normal” times there’s no trustworthy consensus on the
direction of future inflation. Today, however, views have become
particularly polarized, mainly because of the controversy surrounding the rapid and unusual expansion of so-called base money
(currency and reserves created by central banks) as governments in
many countries attempt to remedy the ill effects of the recent
global financial crisis. At the extreme, some fear these “quantitative easing” programs will lead to an out-of-control explosion of
the broader money supply, culminating in runaway inflation.
Meanwhile, with many economies just emerging from recession,
consumer prices low, and unemployment high, deflation seems
to be the more immediate danger. In fact, it’s fair to say that
many economies—the US perhaps foremost among them—
have never before experienced such significant inflationary and
deflationary pressures at the same time. This anomaly has
perplexed most economists and has led to sharply divergent
forecasts for inflation, as seen in Display 22, which shows the
standard deviation of the universe of US inflation forecasts by
Display 22
Inflation Uncertainty Highest Since Early 1980s
Dispersion of Forecasted Inflation Change
Standard Deviation of One-Year Inflation Change Forecasts
2.5
Percent
2.0
1.5
1.0
0.5
0.0
1980
1990
2000
2010
Historical analysis and current forecasts are not guarantees of future results.
Cross-sectional standard deviation of one-year inflation change forecasts (Survey of
Professional Forecasters); through December 31, 2009
Source: Philadelphia Federal Reserve and AllianceBernstein
A Tale of Two “ ’Flations”:
The US Great Inflation vs. Japan’s Deflation
As an example, we need only compare the experience of the US
during its “Great Inflation” of the 1970s with Japan’s deflationary “Lost Decade,” which extended from the early 1990s
through the early 2000s. Perhaps surprisingly, during the decade
ended in 2003, the rate at which the Bank of Japan printed
money exceeded its real economic growth by more than 8% per
year—almost twice the Federal Reserve’s pace during the
10-year period ending in 1980 (Display 23, following page).
If central bank money creation were the key driver, Japan should
have endured a “Greater Inflation.” Yet, while both the US and
Japan experienced shorter-term volatility in their year-over-year
inflation rates during these challenging decades, the US
ultimately experienced 8% inflation, compared with Japan’s 0%
inflation. The apparent paradox has a straightforward explanation: In the US, 4.8% growth in excess base money fueled an
expansion of the broad money supply 8.3% above underlying
economic growth, causing inflation to accelerate. In Japan,
despite significant central bank expansion, the broad money
supply outpaced the country’s growth rate by only 1.9%, and
inflation came in even lower.
Underlying the failure of excess base money to translate into
broader loan growth in Japan were persistent weaknesses in the
Deflating Inflation: Redefining the Inflation-Resistant Portfolio
27
Display 23
A Tale of Two “ ’Flations”:
The US Great Inflation vs. Japan’s Lost Decade
8.3%
8.3%
8.1%
4.8%
1.9%
0.0%
Base Money*
Broad Money*
US
Inflation
Japan
Historical analysis is not a guarantee of future results.
*Money growth rates reflect excess over 10-year real GDP growth. US data are for the
10-year period ending December 1980; Japan data reflect the 10-year period ending
December 2003. US Broad Money reflects M3 aggregate; Japan Broad Money reflects
OECD Broad Money aggregate.
Source: Federal Reserve, GFD, Organisation for Economic Co-operation and
Development (OECD), and AllianceBernstein
balance sheets of both financial institutions and prospective
borrowers. In the wake of the massive collapse in asset values
that followed the bursting of Japan’s investment bubble in the
late 1980s, banks were left saddled with bad loans and were
reluctant to lend, while the corporate sector faced large legacy
burdens and lacked either the eagerness or creditworthiness (or
both) to borrow. With credit contracting, the broad money
supply stagnated.
The US in the 1970s faced no such debt overhang, and despite
many economic problems and policy errors, the era can be
characterized as having strong credit growth and abundant
financial innovation. The 1970s saw the rapid growth of
consumer credit, as well as the expansion of the money-marketfund industry. The decade also gave birth to financial futures
trading and mortgage securities, and saw the rise of the
Eurobond market. All of these innovations allowed the more
efficient translation of narrow money growth into broader
money and credit expansion.
The contrasting experiences of the US and Japan lead us to
conclude that the inflationary implications of excessive central
bank money creation—even over horizons of a decade or
more—are by no means certain.
Taking the Current Inflation Temperature
So what should most investors keep an eye on going forward?
Clearly, elevated money and credit growth is a warning sign.
Another warning sign occurs when the level of aggregate
demand begins to bump up against supply constraints. And
a third is a rise in wages. None of these factors alone causes
inflation, but in combination they are extremely likely to signal
inflationary risk (Display 24).18
What do these factors tell us as of this writing? While narrow
measures of money growth are high in the US and some other
developed economies, broader measures are moderate and will
remain so until banks are more willing to lend and consumers
and businesses are more eager to borrow. Similarly, with
unemployment hovering around 10% and underemployment
far greater than that, wages—and more specifically unit labor
costs—are unlikely to rise dramatically.19 It is difficult for
consumers to bid up prices and largely unnecessary for firms to
Display 24
Three Key Factors to Watch in the Current Environment
Money and
Credit Growth
Wage Growth
Aggregate Demand
vs. Supply
High
High
High
Medium
Medium
Medium
Low
Low
Low
For illustrative purposes only
Source: AllianceBernstein
For more information, see our recent Inflation Fixation white paper.
Technically, wage growth alone is not indicative of inflation risk if it is merely a reflection of concurrent productivity growth. Unit labor cost, a measure of growth in compensation
relative to that of real output, is a more accurate barometer of wage-related inflationary pressures.
18
19
28
AllianceBernstein.com
raise prices in the absence of upward wage pressures. Finally,
slack in the developed world extends beyond the labor markets
into other areas, ranging from vacant real estate to record-low
capacity utilization. It is difficult to raise prices while competition, often global in nature, sits on idle capacity.
Complacency Will Hurt You When You Least Expect It
But these factors can shift rapidly, and other factors could enter
the equation at any time. Existing capacity may shrink faster
than expected due to massive underinvestment or accelerated
obsolescence. A commodity shock could hit both aggregate
demand (as an implicit tax) and aggregate supply (in the form of
higher input prices), leading to stagflation. The markets could
lose faith in a country’s currency, resulting in dramatically higher
import prices. Emerging markets inflation could seep into
developed markets inflation through a variety of channels.
What’s more, any and all of these events could occur suddenly
and without warning, so complacency even over the short term
appears imprudent.
In the medium term, central banks do have powerful tools to
keep money growth within safe territory. But as the old bromide
has it, generals are always fighting the last war—and right now
the enemies are a sagging global economy and the threat of
deflation. How will central bankers assess the prospect of an
adverse inflation surprise, and will they retain sufficient
independence from policy makers to persist in a fight against
inflation? The higher interest rates needed to battle a nascent
inflation are bound to be just as unpopular in the future as they
were in the early 1980s, when the short-term US policy interest
rate rose to a sky-high 22% before finally choking off spiraling
money growth and inflation expectations.
So, while inflation appears subdued globally as of this writing,
we can’t rule out an inflation shock further down the road. To
the extent that the current relative complacency about inflation
makes hedges available and affordable, now is as good a time
as any to buy inflation protection.
And that’s the point behind seeking inflation protection: It’s not
a question of when. You don’t decide to buy insurance for your
home because you think a fire is around the corner. Determining when to purchase an inflation hedge is similar: There may
be little concern today about an imminent spike in inflation, but
who can know when that spike will come? The key is to buy
before the fire. n
Chapter Highlights
n
We do not expect any substantial increase in inflation in the near term.
n
We can be reasonably sure that a spike in inflation will eventually recur; knowing when is a near impossibility.
n
The best result is that disaster (in the form of a sustained rise in inflation) never occurs, and the cost paid turns out to have
been a prudent expense.
Deflating Inflation: Redefining the Inflation-Resistant Portfolio
29
Appendix
Further Details on How Different Assets Respond to Inflation
Bills
Short-maturity bills have historically performed better than
longer-maturity bonds during rising inflation, but “better” does
not necessarily mean “well.” When inflation expectations jump,
outstanding bills lose value instantaneously but still redeem at
par, producing a zero inflation beta. However, new bill yields
generally discount higher inflation expectations, so the shorter
the bill maturity, the more quickly investors capture changes in
inflation expectations. In the extreme, one-day bills should offer
near-perfect pass-through and produce a one-year inflation beta
of around one, which is far better than the negative inflation
betas produced by nominal bonds.
In a diversified portfolio context, however, reducing inflation
exposure by shortening bond maturity toward zero is not an
ideal strategy. Bonds generally help curb the volatility of equities
and other high-risk assets in the portfolio, and longer-dated
bonds can be particularly valuable in bear markets. As Display
25 shows, the longer the bond duration, the better the hedge
to equity risk in most types of equity bear markets (with the
exception of inflation-related bear markets). Therefore, reducing
duration will reduce portfolio inflation exposure, but at the cost
of increasing exposure to most other types of risk.
Nominal Bonds
The impact of rising inflation on nominal bond returns is clearly
negative, and the magnitude of the impact is a direct function of
the bond’s duration. As Display 26 shows, very short-maturity
three-month T-bills posted a modestly positive inflation beta of
0.3. But with bonds having maturities of a year or longer, the
inflation beta becomes increasingly negative. Five-year nominal
bonds declined in value 1.5 times the increase in inflation, while
20-year bonds declined over three times the rise in inflation.
30
AllianceBernstein.com
Display 25
Bonds Usually Hedge Equity Bear Market Risk Better than Bills
Performance During
S&P 500 Peak to Trough*
S&P 500
Trough Date S&P 500
Deflationary
Shocks
Inflation
Neutral
Inflationary
Shocks
Average
{
3-Mo.
T-Bills
6.0%
10-Yr. US
Treasuries
Oct 31, 1903
–25.9%
1.8%
Oct 31, 1914
–25.3
10.8
6.9
Jun 30, 1921
–26.4
9.4
4.3
Feb 28, 1933
–78.3
5.8
16.4
Mar 31, 1938
–49.8
0.3
1.3
Nov 30, 2008
–40.7
1.3
13.0
Nov 30, 1907
–34.1
7.4
0.9
Mar 31, 1935
–20.7
0.2
10.0
Jun 30, 1962
–22.2
1.4
3.2
Jun 30, 1970
–26.9
7.9
–3.1
Nov 30, 1987
–29.6
1.4
1.6
Sep 30, 2002
–44.7
6.8
29.2
Dec 31, 1917
–27.9
5.1
–0.8
Apr 30, 1942
–30.2
0.3
11.6
May 31, 1947
–21.4
0.4
1.4
Sep 30, 1974
–42.6
13.7
0.3
Deflationary
–41.1%
5.6%
7.3%
Neutral
–29.7%
4.2%
6.9%
Inflationary
–30.5%
4.9%
3.1%
Historical analysis is not a guarantee of future results. Individuals cannot invest directly
in an index.
*For equity bear markets since 1900
Source: Federal Reserve, GFD, and AllianceBernstein
Display 26
Display 27
Bond Inflation Beta Worsens as Duration Increases
How Long Did It Take to Regain Peak Purchasing Power?
Inflation Beta by Bond Maturity
Recovery Period*
1965–2008
3-Month T-Bills
0.3
10-Year Treasuries
–0.3
S&P 500
–1.5
–2.2
Commodity Futures
56 Years
50 Years
25 Years
12 Years
Jun 1939–Sep 1995
Dec 1940–Sep 1990
Sep 1929–Dec 1954
Dec 1924–Mar 1937
–3.1
3-Month
T-Bills
1-Year
Treasuries
5-Year
Treasuries
10-Year
Treasuries
20-Year
Treasuries
Historical analysis is not a guarantee of future results.
Source: BLS, Federal Reserve, and AllianceBernstein
The picture worsens when we change the definition of inflation
risk from year-over-year impact on nominal return to the
long-term purchasing power of an investment. Display 27
highlights the longest periods in the 20th century during which
various investments failed to keep pace with inflation. One
dollar invested in three-month T-bills or 10-year US Treasuries at
the beginning of World War II, for example, did not regain its
purchasing power for at least 50 years. That is twice as long as
the period it took for diversified stocks to regain their real value,
and four times as long as commodity futures. Part of the reason
for this drought was the Federal Reserve’s suppression of rates
during and immediately after World War II. But, in general,
nominal government obligations have historically not offered a
high-enough risk premium to overcome the persistent inflation
surprises inherent in inflation cycles.
Alternatively, adding credit exposure to a bond portfolio can
improve the long-term return, but its effect on the inflation beta
is ambiguous. For example, we would expect credit spreads to
tighten during rising inflation as fixed obligations become easier
to pay off with inflated money. Residential mortgage spreads, on
the other hand, should widen as the prepayment option granted
to borrowers becomes more valuable with the increase in interest
rate volatility associated with rising inflation. Historical data,
however, show no clear relationship between spread changes and
inflation changes.
Historical analysis is not a guarantee of future results.
*Length of time before the purchasing power of a $1 investment was restored to $1.
Commodity futures are collateralized by three-month T-bills and are weighted according
to DJ-UBS methodology; prior to 1990 they are on a US consumption–weighted basis
and are sourced from the AllianceBernstein series prior to 1970 and from the MJK
Commodity Futures Database between 1970 and 1990; they are represented by
DJ-UBS thereafter.
Source: BLS, DJ-UBS, Federal Reserve, GFD, London Times, MJK Associates,
NAREIT, The New York Times, USGS, The Wall Street Journal, and
AllianceBernstein
Inflation-Linked Bonds (ILBs)
Inflation-linked bonds were created to pass through the change
in a specified inflation index, so they should provide an inflation
beta to that index of roughly 1.0. While ILBs should clearly play
a role in most inflation-hedging programs, it is important to
acknowledge that a number of issues make these bonds less
than a perfect inflation hedge—the most important of which is
the relationship between real yields and inflation. If changes in
real yield are positively correlated to inflation changes, then ILBs
could lose money during rising inflation, as increases in real
yields hurt ILB prices.
Unfortunately, the precise relationship between real yields and
inflation is difficult to discern and to forecast. While theory
suggests there should be little or no relationship between
inflation and real yields, the short empirical history in the US
and the UK suggests a slight negative relationship, while our
longer-term empirical research indicates a slight positive
relationship in extremes. Given this conflicting evidence, we
expect little or no relationship between real yields and inflation
in the long term. However, in the medium term a plausible risk
exists that rising inflation could coincide with rising yields.
Deflating Inflation: Redefining the Inflation-Resistant Portfolio
31
Continued deficit spending could simultaneously contribute to
inflationary pressures while raising the required real yield
demanded by investors to hold ever-growing amounts of
sovereign debt.
Display 28
Real Estate Inflation Sensitivity Partially a Function of
Land’s Share of Value
Housing Inflation Beta vs. Share of Value from Land
1977–2009
3
Inflation Beta
In addition to having the potential to lose money during rising
inflation, ILBs bring other vulnerabilities, including deflation
exposure, tax inefficiency, and possible manipulation by the
producer of the inflation index. First, the deflation floor built
into many ILBs protects only newly issued bonds. A seasoned
bond that has experienced a rise in the price level from, say,
100 to 110 is left exposed to a decline in the price level back
down to 100. As for taxes, both the coupon and inflation
accrual of US TIPS are taxable at ordinary income rates—the
latter as “phantom income,” because it is not paid out until
maturity. Finally, governments can and do suppress official
inflation numbers to reduce inflation-linked payments. For
example, in 2007 in Argentina, when 40% of the country’s
outstanding debt was in the form of inflation-linked bonds,
the government stood accused of manipulating official
inflation numbers to below 9% from an independently
estimated 25%.
Detroit
2
San Francisco
1
Houston
0
0
25
50
75
Land Value as a Percentage of Total Value
100
Historical analysis is not a guarantee of future results.
Source: BLS, Federal Housing Finance Agency, and AllianceBernstein
Display 29
Farmland Appreciation Tracks Inflation
Farmland and Lumber Prices
10-Year Annualized
10
20
5
10
0
0
–5
–10
10-Year Price Appreciation (%)
Real Estate
Historical analysis is not a guarantee of future results.
Source: BLS, GFD, NBER, USDA, and AllianceBernstein
Also, rental income from most residential and commercial
properties is fixed by lease agreements, so the shorter the lease
term, the more sensitive this income is to inflation, as the leases
will reset with the latest inflation changes embedded in them.
Some countries (Australia, for example) and some property
types (such as retail in certain domiciles) have an explicit link to
local inflation indicators built into rental agreements, so they
serve as particularly good inflation hedges, provided no
oversupply is present.
Agricultural properties such as farmland and timberland can
also provide effective inflation protection, because the income
they generate is tied directly to agricultural commodity prices,
which are inflation-sensitive. Display 29 shows a strong
relationship between rolling 10-year inflation and the prices of
farmland and lumber (a proxy for timber prices). These types of
illiquid real investments are viable substitutes for liquid alternatives such as REITs and commodity futures for investors willing
to take on liquidity risk.
32
AllianceBernstein.com
10-Year Inflation (%)
Because the income that real estate assets produce tends to be
tightly linked to inflation, their inflation betas are generally
considered to be high. The value of a real estate asset derives
from both the actual land and the income it throws off. The
more value tied up in land—a fixed cost—the greater the asset’s
inflation beta (Display 28). For example, in cities like San
Francisco, where the value of land plays a larger role in overall
property value, real estate would provide a stronger hedge to
inflation relative to cities like Houston, where land value plays a
smaller role.
1909 1919 1929 1939 1949 1959 1969 1979 1989 1999 2009
CPI
Farmland
Lumber
Equities
The idea that diversified equities are a good inflation hedge is
true only for very long time horizons. In fact, diversified equities
have usually had negative inflation betas, tending to respond
poorly over the short to medium term in the event of adverse
inflationary surprises. While corporate profit margins do tend to
expand during periods of rising inflation, that alone is insufficient to compensate for the higher discount rate that comes
with rising inflation, resulting in negative inflation betas.
Certain types of equities, however, tend to react better to rising
inflation than others, because their profit margins are especially
sensitive to inflation. The lower the expense sensitivity and the
higher the revenue sensitivity to inflation changes, the more
margins will expand in reaction to rising inflation.
First, let’s consider expense sensitivity. Industries with higher
capital intensity (i.e., higher fixed costs, where input prices don’t
change much in inflation) tend to exhibit better inflation betas
than lower capital intensity industries. We broke out the inflation
betas of different firms based on their capital intensity and
arrayed them in quintiles (Display 30, left). While none of the
quintiles exhibited a positive correlation to inflation changes,
the higher the capital intensity, the less negative the sector’s
inflation beta.
Now for the other element: output prices, or revenues. The
corollary to the notion that high fixed costs = higher inflation
betas is that highly inflation-sensitive revenues = higher inflation
betas. As with capital intensity, we broke out the universe of
equities by market capitalization and graphed them in quintiles
from smallest to largest (Display 30, right). Large-capitalization
stocks tended to respond more favorably to rising inflation than
small-cap stocks did, presumably due to their greater pricing
power and hence more inflation-sensitive revenues. We can see
both of these factors at work in certain natural resource sectors,
which possess a particularly potent combination of high capital
intensity and highly inflation-sensitive revenues, resulting in
positive inflation betas for equities in these sectors.
Commodities
Physical commodities have exhibited and should exhibit strongly
positive inflation betas, primarily due to their relatively inelastic
supply-and-demand traits. Price appreciation during aggregate
demand-related inflations will show up most acutely in goods and
services with the least flexible supply-and-demand response. The
cost and time required to add capacity in energy, mining, and
agriculture (in aggregate) far exceed that for most other goods
and services in consumer price indices. Likewise, the ability to
substitute away from basic resources is far more constrained than
for most later-stage goods.20
Display 30
Equity Inflation Beta Related to Capital Intensity…
…and to Market Capitalization
Inflation Beta by Capital Intensity Quintile Change to Sectors
Inflation Beta by Market Capitalization Quintile
1965–2008
1965–2009
–1.0
–1.1
–1.8
–2.8
–3.6
Low
–2.0
–2.8
Medium
High
Capital Intensity Quintile
–3.4
Small
–3.2
–2.9
Medium
Large
Market Cap Quintile
Historical analysis is not a guarantee of future results.
Source: BLS, Bureau of Economic Analysis, Ken French, and AllianceBernstein
20
Price appreciation during less common aggregate supply–related inflation, on the other hand, will show up most acutely in the goods and services at the heart of the supply shock.
Deflating Inflation: Redefining the Inflation-Resistant Portfolio
33
While commodities and commodity futures hedge against most
types of supply and demand–driven global inflations, they are
not reliable hedges against the country-specific component of
domestic inflations.21 As Display 32 illustrates, when changes in
the domestic inflation rate correlate highly with changes in
global inflation, commodities can be expected to deliver their
characteristically high inflation beta. But to the extent that
domestic inflation shocks are not synchronized with global
trends, commodities are unlikely to perform well as a hedge
against home-country inflation. The most likely cause of
Display 31
Commodity Roll Added Return and Amplified Inflation
Sensitivity
Commodity Roll Return
1900–2009
3.8%
Average
1900–2009
1.9%
–2.9%
Deflations
Rising Inflations
Historical analysis is not a guarantee of future results.
Deflation years: when 10-year rolling rate of CPI inflation is < 0%; rising inflation
years: when 10-year rolling rate of CPI inflation is 3%+ > prior 10 years
Source: DJ-UBS, London Times, MJK Associates, The New York Times,
The Wall Street Journal, and AllianceBernstein
21
Display 32
The Type of Inflation Matters: Global vs. Domestic-Only
Commodity Inflation Beta vs. Global Inflation Correlation
1970–2008*
8
US
6
Inflation Beta
Compared with spot commodity prices, commodity futures
prices have exhibited and should exhibit even stronger inflationhedging characteristics. Levels of contango and backwardation
(when futures prices exceed spot prices and when futures prices
are below spot prices, respectively) that differentiate spot from
futures prices and create roll return are strongly related to
inventories. In demand-driven inflations, inventories get drawn
down and backwardation rises, producing positive roll return for
commodity futures. Display 31 shows that this roll return added
significant return during periods of rising inflation and significantly reduced return during the deflationary Great Depression,
when inventories were high.
Eurozone
4
2
Spain
UK
0
New Zealand
–2
0%
20%
40%
60%
AllianceBernstein.com
100%
Correlation of Domestic with Global Inflation Rate Change
Historical analysis is not a guarantee of future results. Commodity futures are
represented by USD commodity futures returns hedged into domestic currencies.
*1970–2008 for all countries except Australia (1977), Finland (1972), Ireland (1987),
Italy (1977), Japan (1972), New Zealand (1987), Spain (1974), and Sweden (1974)
Source: BLS, DJ-UBS, GFD, MJK Associates, Thomson Datastream, and
AllianceBernstein
desynchronized inflation shocks for most countries comes from
divergent fiscal and monetary policy. However, structural
differences in some economies (such as those heavily dependent
on commodity exports) can lead to similar departures from
global inflationary trends and, as such, a correspondingly lower
commodity futures inflation beta.
Gold
Gold is an enigma, exhibiting characteristics of both a currency
and a commodity, while providing protection against both
inflationary and deflationary environments. Gold production (and
to a lesser extent silver and other precious metals production) is
driven largely by the level of real interest rates (as seen in Display
33) and less by prevailing spot prices. Mine operators have the
choice of extracting gold today or leaving it in the ground to
extract in the future. As real rates rise, the present value of
future extraction falls, so the desire to extract today rises. But
even when global production is “high,” it rarely amounts to
even 2% of all aboveground stocks. This price-insensitive supply
response means that changes in demand are often met by
explosive price responses rather than production responses.
Assumes commodity futures exposures are hedged into domestic currency to separate asset returns from returns associated with foreign currency exposure
34
80%
Display 33
Display 34
Gold Production Driven by Real Yield
Precious Metals Act as a Monetary Disaster Hedge
Real Yield vs. Gold Production
Real Gold Price vs. Yield Volatility
10
30-Day Volatility of 10-Year US Treasury Yields
8
2
–5
–1
Real Yield
–10
1905
–4
1920
1935
1950
1965
1980
1995
2010
Historical analysis is not a guarantee of future results. Real yield is represented by the
AllianceBernstein US 10-year real yield series; and gold production by rolling five-year
global production growth.
Source: BLS, Federal Reserve, Goldman Sachs, USGS, and AllianceBernstein
Demand for gold tends to rise with uncertainty around the
future of the global—and particularly US—financial system, with
gold acting as a currency of last resort. Extreme inflationary and
deflationary outlooks heighten uncertainty—so gold, uniquely,
provides a hedge against both environments. Display 34 shows
how the real gold price tends to rise in periods of high interest
rate volatility, a proxy for monetary uncertainty, and fall in
periods of low rate volatility. Investors tend to flock to gold as a
disaster hedge, regardless of whether the feared disaster takes
the form of a huge inflationary or deflationary shock.
This unique, asymmetric form of hedging, however, comes at a
steep cost. The long-term expected price appreciation for gold (as
for all commodities) is equal to the expected increase in the
marginal cost of production, which, for hundreds of years, has
roughly equaled broader measures of inflation. In other words,
barring “peak gold”-type arguments, the long-term expected
return on a gold investment equals inflation less storage costs—far
below the long-term expected returns on stocks or even bonds.
Further, investors should be skeptical of the reliability of gold as
the ultimate disaster hedge on two counts. First, in the end-of-
Real Gold Price (USD)
0
1,000
0.25
800
0.20
600
0.15
400
0.10
200
0.05
0
0.00
Yield Volatility (%)
5
Real Yield (%)
Production (%)
Production
5
1971 1976 1981 1986 1991 1996 2001 2006 2011
Real Gold Price
Yield Volatility
Historical analysis is not a guarantee of future results.
Source: BLS, Federal Reserve, USGS, and AllianceBernstein
the-world scenario, gold held outside the home will be difficult
to access. Bankruptcies, broken contracts, and even a breakdown in the rule of law could make paper claims on gold
through futures and ETFs worthless and physical gold difficult to
claim. Investors who hold the metal for true end-of-the-world
scenarios should therefore attempt to minimize the number of
counterparties that stand between them and at least a portion
of their gold.
Second, even in a less extreme disaster scenario—where the
rule of law stands but the global financial system fails—gold
may prove an unreliable hedge. Governments have exhibited a
remarkable degree of reliability of their own in decreeing the
value and functionality of gold during times of economic stress.
In the midst of the Great Depression, for example, the US
issued an executive order requiring the surrender of all
nonindustrial gold at $20.67 an ounce and then decreed a new
value of $35 an ounce. While gold does have many positive
attributes, practical realities reduce its reliability as a disaster
hedge and temper the wisdom of relying solely on this
“barbarous relic” for inflation protection. n
Deflating Inflation: Redefining the Inflation-Resistant Portfolio
35
Notes
The data in this paper represent historical index performance and do not represent the investment performance or the actual
accounts of any investors. The information shown is based on back-tested performance over the time periods indicated. It is not
possible for an individual to invest in an index and the markets may perform better or worse in the future.
Although the information contained herein has been obtained from sources believed to be reliable, its accuracy and completeness
cannot be guaranteed. While back-testing results reflect the rigorous application of the investment strategy selected, back-tested
results have certain limitations and should not be considered indicative of future results. Back-tested results assume that asset
allocations would not have changed over time and in response to market conditions, which might have occurred if an actual account
had been managed during the time period shown. AllianceBernstein L.P. may have a different investment perspective and maintain
different asset allocations or other recommendations from those shown here.
36
AllianceBernstein.com
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Deflating Inflation: Redefining the Inflation-Resistant Portfolio
37
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as investment advice.
Past performance does not guarantee future results. Investors cannot invest directly in an index and its results are not indicative of any
AllianceBernstein mutual fund.
Note to All Readers: The information contained herein reflects, as of the date hereof, the views of AllianceBernstein L.P. (or its applicable affiliate providing this
publication) (“AllianceBernstein”) and sources believed by AllianceBernstein to be reliable. No representation or warranty is made concerning the accuracy of any
data compiled herein. In addition, there can be no guarantee that any projection, forecast, or opinion in these materials will be realized. Past performance is
neither indicative of, nor a guarantee of, future results. The views expressed herein may change at any time subsequent to the date of issue hereof. These
materials are provided for informational purposes only, and under no circumstances may any information contained herein be construed as investment advice.
AllianceBernstein does not provide tax, legal, or accounting advice. The information contained herein does not take into account your particular investment
objectives, financial situation, or needs, and you should, in considering this material, discuss your individual circumstances with professionals in those areas before
making any decisions. Any information contained herein may not be construed as any sales or marketing materials in respect of, or an offer or solicitation for the
purchase or sale of, any financial instrument, product, or service sponsored or provided by AllianceBernstein L.P. or any affiliate or agent thereof. References to
specific securities are presented solely in the context of industry analysis and are not to be considered recommendations by AllianceBernstein. AllianceBernstein
and its affiliates may have positions in, and may effect transactions in, the markets, industry sectors, and companies described herein.
Investors should consider the investment objectives, risks, charges and expenses of the Fund/Portfolio carefully
before investing. For copies of our prospectus or summary prospectus, which contain this and other information,
visit us online at www.alliancebernstein.com or contact your AllianceBernstein Investments representative. Please
read the prospectus and/or summary prospectus carefully before investing.
Note to Canadian Readers: AllianceBernstein provides its investment management services in Canada through its affiliates Sanford C. Bernstein & Co., LLC, and
AllianceBernstein Canada, Inc.,This publication has been provided by AllianceBernstein Canada, Inc., or Sanford C. Bernstein & Co., LLC, and is for general
information purposes only. It should not be construed as advice as to the investing in or the buying or selling of securities, or as an activity in furtherance of a
trade in securities. Neither AllianceBernstein Institutional Investments nor AllianceBernstein L.P. provides investment advice or deals in securities in Canada.
AllianceBernstein Investments, Inc. (ABI) is the distributor of the AllianceBernstein family of mutual funds. ABI is a member of FINRA and is an affiliate of
AllianceBernstein L.P., the manager of the funds.
AllianceBernstein® and the AB logo are registered trademarks and service marks used by permission of the owner, AllianceBernstein L.P.
© 2010 AllianceBernstein L.P., 1345 Avenue of the Americas, New York, NY 10105, 1.800.446.6670
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www.alliancebernstein.com
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