Abstract

In this paper, a dynamic inflation-protected investment strategy is presented, which is based on traditional asset classes and Markov-switching models. Different stock market, as well as inflation regimes are identified, and within those regimes, the inflation hedging potential of stocks, bonds, real estate, commodities and gold are investigated. Within each regime, we determine optimal investment portfolios driven by the investment idea of protection from losses due to changing inflation if inflation is rising or high, but decoupling the performance from inflation if inflation is low. The results clearly indicate that these asset classes behave differently in different stock market and inflation regimes. Whereas in the long-run, we agree with the general opinion in the literature that stocks and bonds are a suitable hedge against inflation, we observe for short time horizons that the hedging potential of each asset class, especially of real estate and commodities, depend strongly on the state of the current market environment. Thus, our approach provides a possible explanation for different statements in the literature regarding the inflation hedging properties of these asset classes. A dynamic inflation-protected investment strategy is developed, which combines inflation protection and upside potential. This strategy outperforms standard buy-and-hold strategies, as well as the well-known 1 N -portfolio.

Highlights

  • Governments all over the world have often used inflation to implicitly reduce their national deficit

  • Whereas in the long-run, we agree with the general opinion in the literature that stocks and bonds are a suitable hedge against inflation, we observe for short time horizons that the hedging potential of each asset class, especially of real estate and commodities, depend strongly on the state of the current market environment

  • Whereas in the long run, we agree with the general opinion in the financial literature that stocks and bonds are a suitable hedge against inflation, we observe for short time horizons that the hedging potential of each asset class, especially of real estate and commodities, depends strongly on the state of the current market environment

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Summary

Introduction

Governments all over the world have often used inflation to implicitly reduce their national deficit. In case of stock returns, abundant literature on Markov-switching models is available: [9] divide the stock market into bullish and bearish periods; [10] analyze systemic risk; whereas [11] investigate asset correlations in different regimes. The main contribution of the paper is the development of an investment strategy that decouples its performance from inflation if inflation is low, but dynamically protects the portfolio from losses relative to inflation if inflation is high. Inflation-linked products are excluded, and only the asset classes stocks, bonds, commodities, gold and real estate are considered. Key innovation in this analysis is the use of Markov-switching models for both indicators, the market indicator, as well as inflation.

Inflation-Hedging Properties of Different Asset Classes
Stocks
Commodities
Real Estate
Markov-Switching Model
Markov-Switching Model for the Inflation Rate
Optimal Portfolios
Regime-Dependent Optimal Portfolios
Monthly Time Horizon
Longer Time Horizons
Findings
Conclusions
Discussion
Full Text
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