Portfolio Research

Real Assets, Inflation & Portfolio Performance

By Xiang Xu — Feb 20, 2025

Having experienced the first US inflationary cycle since the mid-1970s, how should investors be thinking about inflation risk and their real asset allocations going forward? Looking back over the last 100+ years, if the past is prologue, then investors may experience inflationary cycles lasting 3y a bit less than once a decade.

US CPI Inflation & Inflation Regimes

 (1913-2024)

(1913-2024)

Note: Inflation is the rolling annualized quarterly percent change in CPI. Inflationary episodes are determined ex post as 2ppt above the trailing 4Q average, with some quarters assigned a regime using our qualitative judgement to eliminate very short, transitory episodes of high inflation. In contrast, when formulating a dynamic real asset allocation strategy, a real-time, ex ante data driven rule is used that assumes only information available in each period and includes data release lags in assessing asset performance (see below for details). Source: Bureau of Labor Statistics, Haver Analytics and PGIM IAS. Provided for illustrative purposes only.
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Note: Inflation is the rolling annualized quarterly percent change in CPI. Inflationary episodes are determined ex post as 2ppt above the trailing 4Q average, with some quarters assigned a regime using our qualitative judgement to eliminate very short, transitory episodes of high inflation. In contrast, when formulating a dynamic real asset allocation strategy, a real-time, ex ante data driven rule is used that assumes only information available in each period and includes data release lags in assessing asset performance (see below for details). Source: Bureau of Labor Statistics, Haver Analytics and PMA. Provided for illustrative purposes only.
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Note: Inflation is the rolling annualized quarterly percent change in CPI. Inflationary episodes are determined ex post as 2ppt above the trailing 4Q average, with some quarters assigned a regime using our qualitative judgement to eliminate very short, transitory episodes of high inflation. In contrast, when formulating a dynamic real asset allocation strategy, a real-time, ex ante data driven rule is used that assumes only information available in each period and includes data release lags in assessing asset performance (see below for details). Source: Bureau of Labor Statistics, Haver Analytics and PGIM IAS. Provided for illustrative purposes only.
Note: Inflation is the rolling annualized quarterly percent change in CPI. Inflationary episodes are determined ex post as 2ppt above the trailing 4Q average, with some quarters assigned a regime using our qualitative judgement to eliminate very short, transitory episodes of high inflation. In contrast, when formulating a dynamic real asset allocation strategy, a real-time, ex ante data driven rule is used that assumes only information available in each period and includes data release lags in assessing asset performance (see below for details). Source: Bureau of Labor Statistics, Haver Analytics and PMA. Provided for illustrative purposes only.

Although US headline inflation has moderated since peaking in mid-2022, core inflation has proven sticky, and concern about inflation risk continues to trend higher along with related focus on real assets.

In speaking with institutional investors, there are three general motivations for considering the inclusion of real assets in a balanced portfolio: greater portfolio diversification, as a source of incremental returns, and as a hedge against inflation risk. Indeed, real assets returns are not highly correlated to either stock or bond returns, they tend to co-move with inflation and have relatively stronger returns when inflation is high and rising.

We explore these three motivations for adding real assets to a portfolio, each with a related portfolio construction methodology, and focus on the impact that inflationary regimes have had on portfolio performance.

Google Trends: Inflation Risk and Real Assets

(2004-2024)

Note: Trailing 6m moving average relative to full sample average. Data are Google trend “all category” US search terms. Source: Google Trends (accessed 04Dec2024) and PGIM IAS. Provided for illustrative purposes only.
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Note: Trailing 6m moving average relative to full sample average. Data are Google trend “all category” US search terms. Source: Google Trends (accessed 04Dec2024) and PMA. Provided for illustrative purposes only.
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Note: Trailing 6m moving average relative to full sample average. Data are Google trend “all category” US search terms. Source: Google Trends (accessed 04Dec2024) and PGIM IAS. Provided for illustrative purposes only.
Note: Trailing 6m moving average relative to full sample average. Data are Google trend “all category” US search terms. Source: Google Trends (accessed 04Dec2024) and PMA. Provided for illustrative purposes only.

Stock/Bond/Real Asset Basket Portfolio Performance by Inflation Regime

(Annualized, 1971-2024)

Note: Inflationary episodes are determined ex post as 2ppt above the trailing 4Q average, with some quarters assigned a regime using our qualitative judgement to eliminate very short, transitory episodes of high inflation. In contrast, when formulating a dynamic real asset allocation strategy, a real-time, ex ante data driven rule is used that assumes only information available in each period and includes data release lags in assessing asset performance (see below for details). Source: Bloomberg, Bureau of Labor Statistics, DataStream, Haver Analytics, Standard & Poor’s, U.S. Treasury and PGIM IAS. Provided for illustrative purposes only. Past performance is no guarantee or reliable indicator of future results.
zoom_in
Note: Inflationary episodes are determined ex post as 2ppt above the trailing 4Q average, with some quarters assigned a regime using our qualitative judgement to eliminate very short, transitory episodes of high inflation. In contrast, when formulating a dynamic real asset allocation strategy, a real-time, ex ante data driven rule is used that assumes only information available in each period and includes data release lags in assessing asset performance (see below for details). Source: Bloomberg, Bureau of Labor Statistics, DataStream, Haver Analytics, Standard & Poor’s, U.S. Treasury and PMA. Provided for illustrative purposes only. Past performance is no guarantee or reliable indicator of future results.
close
Note: Inflationary episodes are determined ex post as 2ppt above the trailing 4Q average, with some quarters assigned a regime using our qualitative judgement to eliminate very short, transitory episodes of high inflation. In contrast, when formulating a dynamic real asset allocation strategy, a real-time, ex ante data driven rule is used that assumes only information available in each period and includes data release lags in assessing asset performance (see below for details). Source: Bloomberg, Bureau of Labor Statistics, DataStream, Haver Analytics, Standard & Poor’s, U.S. Treasury and PGIM IAS. Provided for illustrative purposes only. Past performance is no guarantee or reliable indicator of future results.
Note: Inflationary episodes are determined ex post as 2ppt above the trailing 4Q average, with some quarters assigned a regime using our qualitative judgement to eliminate very short, transitory episodes of high inflation. In contrast, when formulating a dynamic real asset allocation strategy, a real-time, ex ante data driven rule is used that assumes only information available in each period and includes data release lags in assessing asset performance (see below for details). Source: Bloomberg, Bureau of Labor Statistics, DataStream, Haver Analytics, Standard & Poor’s, U.S. Treasury and PMA. Provided for illustrative purposes only. Past performance is no guarantee or reliable indicator of future results.

Four key takeaways for CIOs, asset allocators, and risk managers

 

  • Real assets merit the consideration of inclusion in a balanced portfolio due to a "trinity" of real asset characteristics: diversification, return enhancement, and inflation hedging.
  • Historically, balanced portfolios that include real assets have had higher average returns, lower volatilities, and better risk-adjusted returns relative to a benchmark portfolio of stocks and bonds alone.
  • However, portfolio performance depends on the inflation regime. Historically, stock/bond/real asset portfolios have delivered positive active returns during periods of high and rising inflation but were a drag otherwise.
  • A dynamic real asset allocation strategy which allocates to real assets only when inflation is high and rising, could generate positive active returns and eliminate portfolio drag during other periods. But it does so with slightly more volatility and lower risk-adjusted returns relative to a static buy and hold real asset strategy.
References

Dr. Xiang Xu