A New Look across Asset Classes
May 5, 2009
Long-Term Hedging against Inflation
While effective inflation hedging over periods as short as one year is important, retirement portfolios are more concerned with the performance of various asset classes over longer time frames. To analyze this, the authors used a vector autoregressive (VAR) model. The VAR measures the relative responsiveness of each asset class to surprises or “shocks” in inflation rates.
With a VAR model, researchers make very few assumptions about the underlying model. Bond prices might drive equity prices one day and vice versa the next day. Complex relationships can be modeled where, for example, inflation and asset class returns all impact each other, and the past history of returns for each asset class affects current returns of each asset class.
When I spoke with Roache, he said that the VAR model “allows us to describe all of the different interactions between inflation and the asset classes without imposing too much theory.”
The best way to interpret a VAR model is to not look at equations, but to apply a shock to the system (in this case in the form of a spike in the inflation rate) and trace out its impact on other variables.
Here is what happens to equity returns when a one-standard-deviation spike (equivalent to approximately 0.2%) is applied to inflation rates:
The blue line shows the median return for equities over a 20-year period, bracketed by the red dashed lines, which represent one standard deviation above and below the median.
Equities suffer from the initial inflation shock and fail to recover, even after 20 years. The “problem,” Roache said, “is simply the lack of data available – all we have are positive surprises, at least since the late 1970s and we do not have much evidence on the effect of deflation. Equities have done badly when inflation has gone up unexpectedly.”
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