Inflation Shocks, Inflation Vol Shocks, And 60-40 Returns

Not surprisingly, there has been a lot of debate about the ultimate outcome of the current crisis in terms of causing inflation or disinflation, or even deflation. It is also not surprising that the Keynesians who believe that growth causes inflation have come down heavily on the side of deflation, at least in the initial phase of the crisis. Some nuanced Keynesians wonder about whether there will be a more-lasting supply shock against which the demand-replacement of copious governmental programs will force higher prices. And monetarists almost all see higher inflation after the initial velocity shock fades or at least levels out.

What is somewhat amazing is that there is still so much debate about whether investments in inflation-related markets and securities, such as TIPS and commodities (not just gold), make sense in this environment. A point I find myself making repeatedly is that given where inflation-sensitive markets are priced (inflation swaps price in 1% core inflation for the next 7 years, and commodities markets in many cases are near all-time lows), the potential results are so asymmetrical – heads I win, tails I don’t lose much – that it’s almost malpractice to not include these things in a portfolio. And it’s just crazy that there’s any debate about that. The chart below shows the trailing 10-year annualized real return for various asset classes, as a function of the standard deviation of annuitized real income.[1]

(Click on image to enlarge)

Most of the markets fall along a normal-looking curve in which riskier markets have provided greater returns over time. No guarantee of course – while expectations for future returns ought to be upward-sloping like this, ex-post returns need not be – and we can see that from the extreme deviations of EAFE and EM stocks (but not bonds!) and, especially, commodities. Wow! So if you’re just a reversion-to-the-mean kind of person, you know where you ought to be.

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