Expected Returns: An Investor's Guide to Harvesting Market Rewards

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Inflation factor and inflation premium

• Inflation developments are the main drivers of nominal (fixed income) asset performance but they also influence stock markets and other supposedly real assets.

• Long-dated nominal Treasuries have the most consistent negative inflation sensitivity. The inflation risk premium (IRP) is the key driver of nominal bond risk premium (BRP). This IRP may reflect both standalone inflation uncertainty (which appears to vary with inflation level) and inflation’s covariance with bad times. Both aspects made the IRP especially high in the early 1980s (when the BRP reached between 3% and 4%) and especially low in the 2000s (when the BRP hovered near zero).

• Stocks have been negatively related to inflation in the short term but positively in the long term. The negative relation has both rational and irrational explanations. This relation flips sign in pre-World War II data, however, perhaps due to the changing nature of inflation or the detrimental impact of deflation not seen since the 1930s. Stock market valuation ratios are highest during low but positive inflation.

• Inflation-linked bonds and energy futures, as well as (to a lesser extent) some other commodities and real estate, are good hedges against inflation—which makes them attractive diversifiers.

• Deflation is an even more challenging risk for investors because it hurts all assets except nominal bonds.

• Well-anchored inflation expectations have kept inflation-related premia negligible for ...