Inflation-Hedging Portfolios: Economic Regimes Matter

Abstract

The exceptional rise in government deficits following the subprime crisis, the recent commodity price spikes, and the increase in inflation volatility have revived the debate on medium- to long-term resurgence of inflation. Using a vector-autoregressive model, Brière and Signori investigate the relationships between asset returns and inflation and the optimal strategic asset allocation for investors seeking to hedge inflation risk in two types of macroeconomic regimes. In a volatile macroeconomic environment marked by countercyclical supply shocks, the asset classes of cash, inflationlinked bonds, and precious metals play an essential role. In a more stable environment, such as what has been called the “Great Moderation,” characterized by procyclical demand shocks, the asset classes of cash and nominal bonds play the most significant role, followed by precious metals, real estate, and equities. An ambitious investor in terms of required real returns should have a larger weighting in equities, real estate, and precious metals.

TOPICS: Financial crises and financial market history, VAR and use of alternative risk measures of trading risk, pension funds