After decades of low inflation and a long period in which investors questioned the need for inflation-associated assets, the specter of a sustained bout of inflation has put protection front and center in clients’ minds.
In our experience, most economic models of inflation have historically offered limited value to investors. Inflation can be incredibly hard to forecast — central bankers and investors alike have not always gotten it right. It can sneak up on the unprepared, so we believe that the best way to protect against it is by viewing inflation-linked assets as a strategic “insurance policy” in a portfolio. Like any insurance policy, there's an opportunity cost.
Who should have inflation protection? Our analysis suggests that it's not necessary for all investors but should add value for highly inflation-sensitive clients. Those who are less sensitive may still benefit, but their decision is not as clear-cut.
What makes a client highly sensitive to inflation is a qualitative assessment involving a few important characteristics. First, it’s a function of a client’s risk tolerance, most directly visible in their stock-bond mix. It also depends on the amount of human capital they can convert into financial capital over time (for instance, whether they are working or retired). Finally, the decision hinges on their planned spending rate. Other factors, such as long-term, fixed-rate debt like a mortgage, as well as idiosyncratic exposures, can also affect sensitivity, but to a more modest degree.
We recognize that each person’s sensitivity is unique as one person’s largest spending category varies greatly from another’s. Determining sensitivity is not formulaic, but rather involves a discussion around the tradeoffs.
How much benefit does inflation protection offer? Consider a highly inflation-sensitive investor — a retired 65-year-old with 70% of her portfolio in bonds and 30% in stocks spending 3% of her portfolio per year and aiming to maintain that spending in real terms.
Using our proprietary Wealth Forecasting Analysis, we find that, for this particular investor, inflation protection offers a substantial benefit. The most striking finding in our analysis is that if she faces hostile markets without shielding her portfolio from inflation, she will run out of money by age 95.
That makes sense. But less intuitively, it's not just the bottom end of the range of outcomes where she benefits — her performance improves at the top end of the spectrum as well. By securing significant benefits in inflationary times without sacrificing too much in non-inflationary times, and with the backdrop of low nominal rates, her performance is likely to be improved across the board. Essentially, she hasn't just eliminated poor outcomes, she's shifted up her entire range of potential future returns.
For a less sensitive investor, though, inflation protection offers less impact. When we consider a 45-year-old investor holding 70% stocks and 30% bonds and look ahead 50 years, there's still some benefit in hostile markets, but not nearly as much. And there's a slight cost in more typical or great markets. This investor benefits marginally from inflation protection but may justifiably choose to forego it.
For investors who don't fit neatly into these categories, the most important indicator of their sensitivity will be the stock-bond mix. A retired client with substantial equity holdings will appear more like the 45 year old and a client who is still working and has a heavy bond allocation will appear more like the 65 year old.
When it comes to the protection itself, our preferred hedges respect a client's risk allocation and which assets are being replaced. By replacing a portion of a client's fixed income allocation with real bond strategies rather than nominal bond strategies, we can add that element of protection without distorting the portfolio's expected volatility.
At the same time, even for bond-heavy investors, by replacing part of their equity exposure with a combination of stocks with pricing power, real estate, real assets, and inflation break-evens or swaps, we can incorporate upside from inflationary environments while maintaining higher-than-expected returns across the full economic cycle.
Furthermore, for accredited or qualified investors, alternative asset classes like core real estate or middle market direct lending can offer valuable protection through their high cash flow, floating rate investing structures. For any given client, this type of balanced inflation hedge is likely to be more reliable and robust than an allocation solely to TIPS or gold or agricultural futures. Diversifying exposure across multiple inflation-linked asset classes is our preferred approach.
Bernstein Private Wealth Management has always recognized the extent to which inflation can wreak havoc for certain investors. Now that the markets are increasingly cognizant of that risk, it's a perfect opportunity to remind clients how to consider their inflation sensitivity and, if necessary, to protect against extended bouts of high inflation through a measured strategic allocation approach.
