The new normal is looking more like the old normal. At least when it comes to inflation and the steady rise in prices. After a decade of low inflationary pressures and bouts of deflation, higher prices have come to roost. And while the Fed has done a good job reducing inflation from its highs, the phenomenon is here to stay.
That could prompt some interesting asset allocation changes when building a model portfolio.
The classic 60/40 portfolio may now give way to a 60/30/10 split, with inflation-protected assets now making up a portion of our allocations. For financial advisors and investors using a model, the data is clear for such an allocation.
Inflation Remerges
Truth be told, the last decade has been a fluke when it comes to the market’s normal regime. The severity of the Great Recession and global credit crunch required that policy makers and central banks pull out all the stops. This sent interest rates to zero and even into negative territory in some countries.
Despite low interest rates, the severity of the recession and the overall mixed economic picture managed to keep a lid on growth. Inflation was kept at bay. According to the Brookings Institute, from the fourth quarter of 2007 — the start of the recession — to the fourth quarter of 2010 — the end of the recession — inflation fell from 3.1% to just 0.5%. In the years following, a mixture of factors managed to keep inflation low and even in the negative during select quarters. 1
With this, investors became complacent. Fighting inflation was less of a concern than finding growth.
Then the bottom fell out during the COVID-19 pandemic. Supply chains were closed, production was cut and inflation suddenly went from less than 2% all the way up to 9.1% — a number that hasn’t been seen since the 1980s.
This brings us to today. The Fed’s rate hikes have done a good job of bringing inflation lower. Right now, we’re looking at 2.9%, the lowest it’s been since the pandemic ended.
Sustained Inflation
The question is whether or not we’ll return to the pattern of the post-Great Recession world of sub-2% inflation. The answer may be a resounding “no.”
For starters, investors tend to be really bad at estimating the frequency and magnitude of reported inflation. According to asset manager, AllianceBernstein, over the last 18 years, from 2006 to 2023, actual reported inflation came in above expectations roughly 80% of the time. Analysts and the market managed to miss those estimates by roughly 1.41% on average. This chart from the asset manager highlights the differences. 1
Source: AllianceBernstein
That’s a big difference in predicted and unpredicted inflation amounts.
Moreover, long-term data suggests that today’s current rate of inflation is still too low when looking at the long-term average. Going back to 1914, when inflationary data began to be collected, the U.S. has seen on average inflation of 3.28%. Over the last 30 years, which includes the Great Recession’s low inflation/deflation, the number is still over 2.5%.
There are some major macroeconomic trends helping to keep inflation higher than expected over the long haul.
This includes deglobalization. After the pandemic and the supply chain constraints, firms and consumers realized that our intertwined global economy, while good for prices, may not be good for getting goods into the hands of those that need it. The prolonged onshoring build-out and more domestic production come at the cost of rising prices.
Changes to demographics play a part with an aging population in the developed world coupled with lower overall birth rates. Climate change potentially compounds these issues, with rising severe storm activity and changes to growing patterns adding extra problems to commodities, labor and economic activity.
Allocation to Inflation-Protected Assets
Given the potential for inflation to stay higher for long, investors may want to consider adding inflation-focused assets to their portfolio. Before the Great Recession, this concept of a new 60/30/10 split of stocks/bonds/inflation assets was beginning to form. However, after the Recession, this idea took a backseat. But now could be a great time to revisit it given the return to more normal market conditions.
And it works.
According to a study by PIMCO, adding real assets can help improve portfolio returns and resiliency. Looking at a 50/50 stock/bond mix and adding a mix of real assets Treasury Inflation-Protected Securities (10%), broad commodity exposure (5%) and a dedicated gold allocation (2%) — portfolios realized an improvement in inflation-hedging properties. The original portfolio’s inflation beta stands at -2.1. The new portfolio with the real assets has an inflation beta of -1.3. 2
The addition of the real assets helps on the returns and volatility front as well. In the decade before the Great Recession when inflation was running high, the allocation would have provided an average 1.20% increase in annualized portfolio returns. During the current spike in inflation, the allocation performed better as well.
AllianceBernstein research concludes similar results using strictly TIPS for the inflation protection.
But the basic idea is the same. Investors need to add inflation protection to their portfolios for the longer haul. ETFs can make that allocation easy. There are plenty of real asset ETFs that cover a wide range of inflation-fighting asset classes. TIPS can also be purchased via an ETF or the Treasury directly.
Real Asset ETFs
These ETFs were selected based on their low-cost exposure to real assets and various sub-asset classes within the sector. They are sorted by their YTD total return, which ranges from -5% to 10.5%. They have expense ratios between 0.13% and 0.97% and assets under management between $4.8M and $64B. They are currently yielding between 0% and 4.8%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| EMLP | First Trust North American Energy Infrastructure Fund | $2.44B | 10.5% | 3.5% | 0.96% | ETF | Yes |
| IGE | iShares North American Natural Resources ETF | $514M | 9.1% | 2% | 0.41% | ETF | No |
| RAAX | VanEck Inflation Allocation ETF | $82M | 5.8% | 3.5% | 0.96% | ETF | No |
| IGF | iShares Global Infrastructure ETF | $3.5B | 5.7% | 0% | 0.41% | ETF | No |
| DBC | Invesco DB Commodity Index Tracking Fund | $1.7B | 3.3% | 4.8% | 0.85% | ETF | No |
| RLY | SPDR SSGA Multi-Asset Real Return ETF | $542M | 3.1% | 0.4% | 0.50% | ETF | Yes |
| GNR | SPDR® S&P® Global Natural Resources ETF | $3.4B | 0.8% | 3.5% | 0.40% | ETF | No |
| ASET | FlexShares Real Assets Allocation Index Fund | $10.9M | 0% | 1.1% | 0.97% | ETF | No |
| IQRA | IQ CBRE Real Assets ETF | $4.85M | -0.2% | 2.2% | 0.92% | ETF | No |
| VNQ | Vanguard Real Estate Index Fund | $63.6B | -5% | 3.5% | 0.13% | ETF | No |
TIPS ETFs
These funds were selected based on their exposure to Treasury Inflation-Protected Securities (TIPS). They are sorted by their YTD total return, which ranges from -4.3% to 1.3%. They have expenses between 0.03% and 0.20% and assets under management between $500M and $52B. They are currently yielding between 0.2% and 8.9%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| VTIP | Vanguard Short-Term Inflation-Protected Securities Index Fund | $51.8B | 1.3% | 0.2% | 0.04% | No | |
| TDTT | FlexShares iBoxx 3-Year Target Duration TIPS Index Fund | $1.8B | 0.7% | 8.9% | 0.19% | ETF | No |
| TIPX | SPDR Bloomberg 1-10 Year TIPS ETF | $1.33B | 0.1% | 7.5% | 0.15% | ETF | No |
| TIP | iShares TIPS Bond ETF | $18.8B | -0.6% | 7.8% | 0.19% | ETF | No |
| SCHP | Schwab U.S. TIPS ETF | $11.3B | -0.6% | 4.8% | 0.03% | ETF | No |
| DFIP | Dimensional Inflation-Protected Securities ETF | $507M | -0.7% | 4.7% | 0.12% | ETF | Yes |
| LTPZ | PIMCO 15+ Year U.S. TIPS Index Exchange-Traded Fund | $720M | -4.3% | 8.1% | 0.20% | ETF | No |
No matter how investors add the exposure, the message is clear — inflation isn’t going away and will most likely stay elevated and close to historic norms going forward. That means portfolios need to be prepared to fight inflation. Perhaps changing our model’s allocations to include a direct weighting towards these assets makes a ton of sense.
Bottom Line
After years of low to no inflation, the hand of rising prices is back with a vengeance. And it should stay that way. Various macroeconomic forces along with a reversion to the mean all point towards higher inflation rates for the long haul. Investors should prepare by reallocating a portion of their portfolios to inflation-protected asset classes.
1 AB (April 2024). Core Portfolio Construction Principles
2 PIMCO (February 2024). Real Assets: Bolstering Portfolios as Inflation Lingers