Inflation-hedging portfolios in Different Regimes

The unconventional monetary policies implemented in the wake of the subprime crisis and the recent increase in inflation volatility have revived the debate on medium to long-term resurgence of inflation. This paper presents the optimal strategic asset allocation of an investor seeking to hedge inflation risk in different macroeconomic regimes. Using a vector-autoregressive model (VAR) for the joint dynamics of asset returns, inflation and other state variables, we investigate in the context of a simulation that allows for serial and cross-sectional inter-temporal dependencies the relationship between asset returns and different economic variables, at different investment horizons. We then study the optimal portfolio choice for the investor seeking to attain a fixed target for real returns on his investment horizon, with a shortfall probability constraint. We show that the strategic asset allocation differs sharply across regimes. In a volatile macroeconomic environment, inflation-linked bonds, equities, commodities and real estate play all an essential role in hedging a portfolio against inflation. In a more stable economic environment (“Great Moderation”), nominal bonds play the most significant role, with equities and commodities. An ambitious investor in terms of required real return should have a larger weighting in risky assets, especially commodities. We show the optimal allocation for each investor, depending on his target real return and tolerated shortfall probability.