Inflation vs Stagflation - How do Real Asset Portfolios Differ?InflationvsStagflation-HowdoRealAssetPortfoliosDiffer?

Asset returns and volatilities vary depending on the underlying economic environment.  For example, in an environment of low economic activity and high inflation – stagflation – the average annual S&P 500 return is 7%/y.  In contrast, the average annual S&P 500 return across all high-inflation environments is 11%/y, a difference of 4%/y. 

Just as returns and volatilities vary, the sensitivities (i.e., betas) of real assets to inflation and economic growth also change depending on the economic environment, and these sensitivities should inform a CIO’s real assets portfolio construction.  A CIO constructing an inflation-protection real assets portfolio, but who has no view on economic growth, may wish to target a portfolio inflation beta using inflation betas across all economic environments.  

However, suppose a CIO has a view that inflation is coming.  A CIO having a view of a high-inflation environment may wish to construct a real assets portfolio with a high inflation beta using betas estimated only from high-inflation environments, regardless of the growth environment.  In contrast, another CIO may share the view that inflation is coming but also has the view of slower economic growth (i.e., stagflation).  In this case, the CIO may wish to construct a real assets portfolio, with a high inflation beta and a low growth beta, using betas estimated specifically from stagflation environments. 

To show why this distinction in views is important for portfolio construction, consider two real asset portfolios: Inflation and Stagflation.  We use the RASA® methodology to construct each portfolio that maximizes the ratio of the portfolio’s inflation beta to the volatility in the portfolio’s estimated inflation beta.  For the Stagflation portfolio we also constrain the portfolio’s growth beta to be low.  Note that the betas used for the Inflation portfolio are estimated across all high-inflation environments, whereas the Stagflation betas are estimated only from stagflation environments.

For the Inflation portfolio, simply maximizing the portfolio’s inflation beta results in the portfolio having a relatively high growth beta of 0.05 during stagflation, but a lower growth beta of 0.037 across all economic environments.  So, we see that an effective stagflation portfolio must explicitly reduce the portfolio’s growth exposure if stagflation were to occur, validating the CIO’s view.  For the Stagflation portfolio, we assume the CIO constrains the portfolio’s growth beta to be less than 0.015, making the portfolio less sensitive to below-trend growth compared to the Inflation portfolio.  Despite the Stagflation portfolio having a lower beta to economic activity, the portfolio has approximately the same inflation beta of 7 (i.e., a 1%/y increase in average 3y realized inflation increases portfolio returns by 7%/y) as the Inflation portfolio.