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Inflation Regime Shifts: Implications for Asset Allocation

October 11, 2012

Further, we believe asset prices are much more sensitive to inflation outcomes relative to expectations than actual inflation levels – i.e., investors can react strongly when outcomes differ from expectations. Historically, inflation regime shifts have occurred with little warning. And once a growth spark ignites the inflation gasoline left everywhere by central banks (most recently the Fed with QE3), it may be too late to hedge the effects of inflation.
-Nicholas J. Johnson and Sebastien Page, executive vice presidents, PIMCO

  • We believe that asset prices are much more sensitive to inflation surprises than actual inflation levels themselves.
  • Given the current macro environment, investors face the possibility that low growth and high inflation may coexist.
  • Commodities provide a levered response to inflation. Investors can hold a relatively small amount of commodities to hedge a much larger portfolio.

Over the past thirty years, inflation in the U.S. has averaged just below 3% per year. For many investors, we fear this extended period of price stability has created a complacency about the impact inflation can have on the returns of different asset classes.

But the events that have unfolded since the credit crisis of 2008 should challenge this attitude. First, the crisis reminded investors that the fat tails in financial markets are large – and the previously unthinkable can quickly turn into reality. Second, the crisis sowed the seeds for the possibility of rising inflation. Central banks have increasingly engaged in unconventional monetary policy, and debt levels among developed market governments have ballooned. Monetization of government debt through inflation could be a logical result.

Further, we believe asset prices are much more sensitive to inflation outcomes relative to expectations than actual inflation levels – i.e., investors can react strongly when outcomes differ from expectations. Historically, inflation regime shifts have occurred with little warning. And once a growth spark ignites the inflation gasoline left everywhere by central banks (most recently the Fed with QE3), it may be too late to hedge the effects of inflation.

Therefore, now may be the time for investors who are concerned about inflationary risks to focus on increasing their exposure to asset classes that tend to provide a positive beta to changes in inflation.

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