But our research highlights an additional threat from higher inflation, one that could result in higher-than-expected portfolio risk via a reduction of diversification benefits.
Inflation doesn’t just jeopardize a portfolio’s ability to generate real returns. It can undermine its ability to mitigate risk as well. Understanding this dynamic is particularly important to more risk-averse investors focused on income and downside protection, such as investors in and near retirement.
High-inflation environments impact how different assets perform relative to each other, as measured by the correlation between stocks and bonds. In normal low-inflation environments, asset returns are primarily affected by growth and flight-to-quality shocks, which have the opposite effect on the prices of stocks and Treasury bonds. But when inflation is high and volatile, inflation shocks dominate, and these can shift stock and bond prices in the same direction.
This behavior should be incorporated into multi-asset portfolio design and management and how practitioners measure the diversification benefits these portfolios offer, especially for those nearing and in retirement.
Inflation dynamics show that the inflation rate follows persistent long-term trends, with considerable volatility over the short term. Moreover, asset class returns and inflation jointly exhibit persistent regimes, where both the average rate of inflation and the correlation among asset class returns shift together.
Asset correlations are a key input into portfolio construction. Therefore, in constructing portfolios with inflation risk in mind — and understanding how they may respond to changes in the long-term inflation regime — it is important to take these dynamics into account, for example when running Monte Carlo simulations.1