Morgan Stanley IM: Managing Inflation Risk through Improved Portfolio Optimization

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• In a global economy driven by an unprecedented combination of forces, sophisticated investors need improved tools to cope with inflation and growth surprises.
• The August 2022 CPI report was typical of the recent stream of surprise data, defying expectations for decelerating inflation. At the same time, various GDP tracking tools indicated below-trend or negative levels.
• As of August 2022, the latest median forecast of Survey of Professional Forecasters expected 1-year-ahead inflation to be 3.6% and growth to be 2.3%.
• New research by Morgan Stanley Investment Management offers a portfolio construction framework that fully optimizes inflation hedging and incorporates investor preferences and expectations.
• This paper offers an improved method for optimizing portfolios in a range of inflationary and growth scenarios, and then suggests appropriate allocations for a range of institutions:
• First, we characterize how assets perform under different market environments, across inflation and growth surprises, based on their sensitivity to those surprises, also taking into account the reliability of those characteristics. This framework is included in a more traditional optimization model that incorporates the risk/return profile of each asset class, as well as investor risk preference.
• Second, we outline portfolios that may be suitable for pension plans, life insurers, and endowments and foundations for a range of target tracking errors.

Broad Findings

Our broad findings show that asset classes can be categorized by their typical responses to inflation and growth surprises: 1) ones that are mainly driven by growth surprises, like public and private equities; 2) ones that are driven by inflation, such as commodities; and 3) ones that are driven by both inflation and growth.

Because assets span this spectrum, how one hedges inflation, and the funding source, depend on the intersection of both types of surprises.

The paper suggests a number of perhaps non-obvious implications for asset allocators including:

As a baseline scenario, (e.g., when growth surprises are modest), equity allocations should not vary significantly with inflation. Related, reducing the fixed income allocation is a dominant funding source for more inflation-oriented portfolios.

When stagflation prevails, TIPS will likely be a more attractive hedge, while in an overheating environment, commodities will be more attractive.

Similarly, the role equity plays also varies highly—when stagflation prevails, reducing the equity allocation will be a dominant source for funding hedging assets, but in an overheating environment, only modest equity reductions are called for.

Finally, within equities, high inflation has historically made private equity even more attractive relative to public equity. This can also remain true going forward due to the concentration of private equity in secular growth areas such as technology, and healthcare which may increase prices easily.

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