Unexpected inflation resulting from mounting debt burdens and easy monetary policy in developed nations could reduce the values of stocks and bonds, according to a report from Mellon Capital Management.
“Since the onset of the financial crisis in 2008, both fiscal and monetary policies across the globe have been unprecedented,” says Karsten Jeske, co-author of the report and senior research analyst at Mellon Capital. “The US especially has been troubled by persistently high deficits, with one trillion dollars added to its deficit each year since 2008.”
In addressing this potential threat, Mellon Capital has unveiled a programme to help investors optimise the tradeoffs among expected returns, portfolio volatility and unexpected inflation.
The programme is detailed in its report, Unexpected Inflation Hedging: A 3D SUPER Approach. The report distinguishes between expected inflation and unexpected inflation, which it defines as the difference between realised inflation and expected inflation for the same period.
“Past experience indicates that unexpected inflation is detrimental to both equity and nominal bond returns, while some other asset classes such as commodities and commodity-sensitive equities can help alleviate this risk,” says Anjun Zhou, the other co-author of the report, and head of multi-asset research, of Mellon Capital. “However, trying to anticipate unexpected inflation by moving into passive commodity indices would come at a cost, because these assets tend to have lower expected returns.”
In its report, Mellon Capital extends the Modern Portfolio Theory by establishing a three-dimensional efficient frontier surface, which it uses to help determine the optimal trade-off among expected returns, portfolio volatility and unexpected inflation. The Mellon Capital programmes are designed to move the efficient frontier upwards with the goal of providing improved unexpected inflation protection that would not have to reduce expected return.