On Inflation, Prepare for the Unexpected

Even in low-inflation environments, portfolios remain at risk of inflation surprises, argues Meketa.

Inflation levels are low and expected to remain low—but that’s no excuse for not protecting against unexpected moves, according to Meketa Investment Group.

The Boston-based consultant advocated for allocations to inflation-protected bonds and real assets to safeguard portfolios against sudden inflation spikes.

“Holding assets that do not decline in real value during unexpected inflationary periods enhances the ability of the total portfolio to make payouts while protecting its value on the downside,” the authors wrote. “This diversification reduces the volatility of the total portfolio’s value, even though the inflation-hedging assets may demonstrate considerable volatility when viewed in isolation.”

Over the last ten years, the rate of inflation has declined consistently, and traditional inflation hedges like commodities and natural resource equities have performed poorly. However, Meketa said these assets remain a “useful complement” to equity-dominated portfolios, as equities tend to be hit hard by inflation shocks.

“Inflation surprises have historically been damaging to equity and bond portfolios alike,” wrote Roberto Obregon, Frank Benham, Edmund Walsh, and Timur Yontar, who authored the report. “Because inflation surprises are, by definition, unexpected and historically common, we recommend that investors allocate to inflation-hedging assets.”

The report highlighted four asset classes that provide protection against inflation: commodities, real assets, natural resource equities, and treasury inflation-protected securities (TIPS).

According to Meketa, commodities and natural resources act as effective inflation hedges because they have an inverse relationship to equities and fixed income, performing worse in low inflation environments and best during positive inflation surprises.

Real assets, meanwhile, have an “intrinsic level of real value that remains relatively stable in periods of inflation,” they explained—though since they also come with liquidity constraints, they can’t be relied upon to fund payouts.

TIPS by definition also hedge against inflation, with the trade-off of high exposure to interest rate risk.

“Institutional investors need to evaluate the magnitude of their need for inflation-hedging assets, and once established, consider allocations from a total portfolio perspective that evaluate the tradeoffs and risks involved in investing in discrete inflation-hedging assets,” the authors concluded.

Related: The Great Inflation Condundrum