On the flip side, Rising Inflation brings  an equal uncertainty towards real asset  pricing, with a hypothetical tax-like  impact on real assets. Although opposite  within this inflationary spectrum,  its impact on real values differs greatly  across asset classes. Most pension plans  in the days of Disinflation held generic  balanced fund exposure of 60 per cent  equities, 30 per cent bonds, and 10 per  cent cash. Exotic investing was considered  going offshore, and those that did  held a home country bias. Very few  pension plans held any meaningful exposure  to private equity or hedge funds. 

Diversification was typically holding  two to four balanced fund products,  where the funds manager was responsible  for managing both the security  selection and asset allocation.  Ri sing inflati on  This question has a personal  relevance for me. Amongst his many  accomplishments at the Inter-American  Development Bank (IDB), my father  was instrumental in developing the IDB  pension scheme in the early 1970s. At  the time, the US was just entering one  of the worst economic environments,  one that would last until 1982 – rising  inflation.

Regardless of the asset allocation  mix, real returns fell way short  of the intended pension immunisation  target of CPI plus 4 per cent.  As previously mentioned, however,  all asset returns struggled during this  period. At first glimpse the return  numbers don’t look too bad, but once  you deduct the tax-like impact of  inflation, real returns look remarkably  poor. All assets had underperformed  GDP growth. Of the major assets,  only equities delivered some positive  real returns, albeit by a miserly 29  basis points. Much of this positive  result stemmed from the inflation pass  through provided by dividends/profit  payout. Conversely, cash delivered a  negative real return of 9 basis points,  with long government bonds delivering  a negative real return of 1.33 per cent.  CIOs targeting immunised results of  CPI plus 4 per cent fell well short. 

The second worst period for allocating  between asset classes was during  the depression period of the 1920s and  30s. Unlike the inflationary period in  the 1970s where nominal GDP was  positive, under the deflationary 1920s  and 1930s nominal GDP and profit  growth were flat. During this deflationary  period, inflation averaged around  negative 2 per cent. Interestingly, real  GDP growth varied little through these  four secular inflationary cycles.  In the rising inflation period equities  outperformed bonds.

However,  under the weak nominal GDP scenario,  investors sought refuge in defensive  assets with their fixed coupons and  income. Intuitively, much of this stems  from accessing a fixed coupon payment  during a period of contracting  GDP and corporate profitability. This  scenario, where bonds outperform  equities when nominal GDP is weak,  is observed more recently in Japan  where bonds have delivered a handsome  outperformance when compared to the  broad equity market.