Inflation hurts investors in many ways, and thus planning for it is an important part of the investment process. Traditional bondholders, for example, suffer when inflation erodes the purchasing power of their fixed coupon payments. Similarly, stock investors lose, particularly over the short term to intermediate term, when their dividend payment and capital appreciation don’t keep pace with inflation, largely because the companies themselves have a difficult time raising prices fast enough to match the inflation-led increases in expenses. In the long run, companies can pass inflationary costs (e.g., labor and materials) on to their customers. But it can take years for this “pass-through” to make its way through the economy.

After years of relatively benign inflation, investors are starting to worry about higher levels of inflation in the (near) future. For example, immense fiscal deficits, as far as the eye can see, have many believing that the United States will try to “reflate away” its substantial debt burden. This concern is priced into the Treasury markets now, with 10-year breakeven rates—that is, the yield difference between nominal Treasuries and TIPS—ramping up from essentially zero at the start of the year to 1.8% per annum at the end of May.

Many investors have most of their liquid assets in mainstream stocks and bonds. So, if inflation is about to rear its ugly head for the first time in a quarter century, most of us are badly exposed. Given their vulnerability to inflation, many investors are adding dedicated “real return” assets to their asset mix. This shift is in the early stages, with most investors concentrating on those asset classes with the most direct link to inflation, such as TIPS and real estate. These allocations to real return assets are rarely done in a diversified way, and even more rarely on a scale large enough to matter. We find that a real return mandate works better if it embraces an opportunistic and tactical approach to the puzzle built on a broader tool kit of asset classes.

Real Return Choices

So, if inflation is a real threat, what choices does an investor have for generating real returns?

TIPS is the logical choice for real return allocations because of its structural link to rising prices. Other asset classes, such as real estate, commodities, infrastructure, and timberland, are also attractive because of their lower correlation with stocks and bonds.

Another way to assess the attractiveness of an asset class is to look at its correlation with inflation. Table 1 illustrates the quarterly correlation to inflation of a wide roster of asset classes since the inception of the S&P Global Infrastructure Index in 2002.

As Table 1 shows, traditional stocks and bonds offer little protection from inflation over this time period—hence the reason for the expansion of real return programs across institutional and private portfolios. Most of the commonly accepted real return asset classes (highlighted in blue) provide significantly better inflation protection—as we would expect. Timberland is an odd outlier, but this may be due to the use of land appraisals in assessing the returns: When inflation accelerates, it may be reflected in the appraisals in future quarters, not the current quarter.

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