October 2021

When Stock-Bond
Diversification Fails
Managing inflation risk in investor portfolios

The quarter century from the mid- used car prices, as a reason why these
1990s to 2020 was a period of credible pressures may not persist. Longer-
central banks across developed term expectations remain fairly well-
markets, low and stable inflation, and anchored as of September 2021.2 At
well-anchored inflation expectations. the same time, uncertainty around the
Yet, unprecedented monetary stimulus, future path of inflation should prompt
dating back to the Global Financial investors to question how different
Crisis, coupled with extraordinary inflationary outcomes can impact their
fiscal stimulus and potential supply portfolio. This is the subject of this
chain disruptions stemming from the article and the outline is as follows.
Covid-19 pandemic, has raised renewed
concerns about the potential for upside We first introduce measures that isolate
shocks to inflation. the “news” components of inflation
and are therefore most relevant to
In 2021, inflation increased sharply, asset prices. Using these measures, we
Ashwin Thapar
reaching 5.4%1 in the U.S. for the year evaluate the sensitivity of traditional
Principal, AQR
ending in June, and maintaining that markets – stocks and nominal bonds
Thomas Maloney rate three months later. Perhaps even – to inflation, showing potential
Managing Director, more notably, U.S. core CPI, which underperformance in environments
AQR strips out more volatile energy inputs of rising or surprisingly high inflation.
(often the cause of major swings – both In other words, the diversification that
Alfie Brixton, CFA positive and negative) exceeded 4% stocks and bonds have historically
Vice President, AQR for the first time since the early 1990s. provided in growth shocks may weaken
Many have cited “base effects” and if high inflation rears its head.
We thank idiosyncratic (and likely short-lived)
Antti Ilmanen, pressures on individual components We next evaluate other asset classes
Michael Katz, Tobias of the Consumer Price Index, e.g., that are often considered to offer more
Moskowitz, Lars
Nielsen and Jordan 1 Bloomberg, Bureau of Labor Statistics.
Brooks for their 2 While the 5-year breakeven inflation rate at 2.5% was the highest for more than a decade, the 5-year 5 years
forward rate (a measure of longer-term expectations), was at a less exceptional 2.2%, a level exceeded for
helpful comments. substantial periods of the 2010s.
2 When Stock-Bond Diversification Fails: Managing inflation risk in investor portfolios | October 2021

resilience to inflation, including real estate, protection without suffering in disinflationary

commodities, and inflation-linked bonds. We recession outcomes. We present two active
show that allocations to some (but not all) strategies that seem to fit this bill – price trend
of these asset classes can provide valuable following and macro momentum. These
diversification in inflationary episodes and strategies have tended to outperform during
thus reduce portfolio sensitivity to inflation. both upside and downside inflation surprises,
i.e., they have shown “convexity” to the
Diving deeper into the relationship between inflation environment.
asset classes and inflation, we see an empirical
tendency for equities to also underperform We conclude by analyzing the impact on
during periods of falling inflation – potentially a traditional portfolio of an allocation to a
due to these episodes having coincided with “real return” basket, including commodities,
adverse growth shocks in our sample. This TIPS breakevens, price trend, and macro
pattern highlights the benefit to investors of momentum, showing meaningfully improved
strategies that might offer upside inflation resilience to the inflation environment.

I. Challenges, Caveats and Metrics

There are many challenges associated with of expectations (previous year’s inflation
the analysis of sensitivity of asset prices to sets expectations for next year’s), and the
inflation. Macro variables, such as inflation, second using surveys as a proxy for market
can be slow moving with some degree of expectations. While neither is perfect, the
predictability. Asset prices likely already reflect combination of the two metrics (standardized
prevailing levels of inflation, and instead so they have equal influence3) may serve to
respond to inflation news. Therefore, when reduce noise in either one. By focusing on
measuring sensitivities it is critical to extract quarterly overlapping year-on-year periods, we
the news component of inflation. To do so, we avoid seasonal effects and mitigate the role of
combine two measures of the “information publication lags. We construct a corresponding
content” of realized U.S. inflation: metric for U.S. GDP growth, as a control
variable.
1. Year-on-year CPI inflation minus CPI for
previous 1-year period (“change”) The choice of sample period is an important
and non-trivial one: there is a clear trade-off
2. Year-on-year CPI inflation minus 1-year between including more data versus focusing
forecast at start of period (“surprise”) on more recent periods with greater relevance
and better data quality and availability. Long
Both can be thought of as measures of the histories of inflation span different monetary
surprise in inflation – with the first using a systems not fully applicable to the current era.
simple “random walk” model for the path In addition, some relevant assets have had a

3 Changes tend to be larger in magnitude than surprises, so a simple average gives more weight to them. By scaling the two series to
have the same standard deviation before averaging, we ensure equal weight is given to surprises, to which asset returns tend to have
higher sensitivity.
 When Stock-Bond Diversification Fails: Managing inflation risk in investor portfolios | October 2021 3

relatively brief existence.4 On the other hand, inflation environments as shown in Exhibit 1.
more recent periods contain few inflationary In making this choice, we accept some risk that
episodes. As a middle ground, we choose to the Great Inflation of the mid-70s to early-80s
analyze the 50-year period from 1972 to 2021, may drive some sample-specific results. Our
which is relevant to the current regime, allows analysis focuses on U.S. inflation, where the
us to test a wide range of assets and strategies, best data are available, but we find similar
and still encompasses a wide range of different patterns in other major markets.5

Exhibit 1: Historical U.S. 12-Month Inflation and Growth Changes and Surprises
Jan 1972 – Jun 2021
a. Inflation Metrics b. Growth Metrics
10% 10%

5% 5%

0% 0%

-5% -5%

-10% -10%
1970 1980 1990 2000 2010 2020 1970 1980 1990 2000 2010 2020
YoY Change Past 12M Surprise
Source: Fed Survey of Professional Forecasters, U.S. Bureau of Labor Statistics, Bloomberg and AQR. Data at quarterly frequency.
Changes are calculated as simple difference between year-on-year inflation and year-on-year inflation 12 months earlier. Surprises are
calculated as simple difference between year-on-year inflation and 1-year forecast 12 months earlier. Please read important disclosures in
the Appendix.

II. The Sensitivity of Traditional

Markets to Inflation
We start by analyzing the sensitivity of Chart A shows the correlations of the
traditional markets to inflation. We analyze three portfolios to our inflation metric and
a portfolio of domestic equities represented its components. All three have negative
by the S&P 500 index, bonds represented by sensitivity, indicating a tendency to
a 10-year U.S. treasury index, and a 60/40 underperform during inflationary episodes.
combination of the two, as shown in Exhibit 2. The result for bonds is unsurprising: a
claim on a fixed set of nominal cash flows
is intuitively less valuable when prices have

4 The first Treasury Inflation Protected Securities (TIPS) were introduced in the U.S. in 1997. Other markets, e.g. the U.K. (1981) have
had longer histories, while others, e.g. Germany (2006) have had shorter still.
5 Specifically, we examine the sensitivities of euro-area equity and government bond portfolios to changes in euro-area inflation, and find
very similar results to those set out below for U.S. assets.
4 When Stock-Bond Diversification Fails: Managing inflation risk in investor portfolios | October 2021

risen unexpectedly.6 The result for stocks may were lowly correlated on average, controlling
be less obvious – if companies’ earnings can for growth raises explanatory power and
increase along with the CPI, leaving stock statistical confidence. The panel illustrates the
investors with a claim on real cash flows, then perniciousness of inflation, relative to growth,
shouldn’t stocks be unimpacted by inflation? for holders of 60/40 portfolios. While the two
There may be several reasons why not: not components have strong diversification along
all companies may have the flexibility to the growth dimension,10 with stocks having
adjust prices, investors may have a tendency positive exposure and bonds negative, this
to discount the real cash flows of stocks diversification is sorely lacking when it comes
with nominal discount rates,7 investors may to inflation.11
anticipate higher real rates as an eventual
consequence, or the economic inefficiencies Chart C digs deeper into the effect described
and uncertainty associated with inflationary in Chart B by specifically evaluating the
episodes may impair real growth and/or drive statistical diversification potential of stocks
an increase in risk aversion and required relative to bonds in “growth news dominant”
return for risky asset classes such as equities. and “inflation news dominant” environments.
The last explanation is consistent with analysis We partition periods into those when the
later in the paper showing that stocks may be magnitude of growth surprise exceeds that of
short “inflation volatility” as well as having inflation surprise and those when the opposite
some linear negative exposure. In the appendix is the case. We see that during periods when
we show results for equity sectors and for non- growth news has dominated, the stock-bond
U.S. equities, and these results suggest some correlation has been near zero. This has
tilts which could be made within the equity represented a majority of the time since 1990
allocation to increase inflation resilience. 8
and is one explanation for the environment
Finally and intuitively, the 60/40 portfolio has of low-to-negative correlation between stocks
sensitivity between that of stocks and bonds.9 and bonds that investors have enjoyed.
However, in the periods when inflation news
Chart B shows partial correlations of stock has dominated, stocks and bonds have been
and bond returns to both inflation and growth positively correlated. Unlike growth news
variables. This two-factor analysis accounts which tends to drive stocks and bonds in
for any interaction between the two macro opposite directions, inflation news (especially
variables. Although during this particular to the upside) tends to drive them in the same
sample, our growth and inflation news metrics direction.12

6 We focus here on Treasuries but we also tested credit. Credit excess returns exhibit a mild negative sensitivity to inflation. Corporate
bonds have a strong sensitivity due to the accompanying rates risk.
7 Consistent with the so-called “money illusion”.
8 We tested a proxy for private equity, combining buyout (private) and levered small-cap (public) indices, which has a negative sensitivity
too.
9 We find some evidence of time variation during our sample period, with stronger sensitivities from 1972 to 2000, and weaker
sensitivities thereafter. On the one hand, this raises the possibility some structural change has weakened sensitivities. On the other, it
could suggest that a return to a more volatile inflation environment would see stronger sensitivities than the full-sample averages we
report here.
10 That said, the tendency of a 60/40 portfolio to be dominated by stock risk means that it is still “growth exposed”. Investors (particularly
those with an ability to take leverage) may seek to improve the growth diversification of this portfolio by improving the risk balance
between the two – generally achieved by using leverage to increase the risk in the bond portfolio.
11 To give a sense of economic significance, equities’ and bonds’ betas to our inflation metric are -2.2 and -1.3 respectively, meaning
that a 1% rise in inflation over 12 months is associated with a reduction in returns of 2.2% and 1.3%. The full sample average returns
are 5.6% for equities and 1.7% for bonds, in excess of cash. See Exhibit 4 for additional insight into the economic impact of inflation
shocks.
12 The topic of time-varying correlation between asset classes is an important one deserving of more in-depth study. For a richer and
more complete analysis, see Brooks and Ilmanen (2022).
 When Stock-Bond Diversification Fails: Managing inflation risk in investor portfolios | October 2021 5

Exhibit 2: Historical Inflation and Growth Sensitivities of U.S. Equities and Treasuries
1972-2021
a. Inflation Sensitivity b. Growth and Inflation Sensitivities
U.S. U.S. U.S. 0.5
Equities Treasuries 60/40
0.0 0.4
Equities
-0.1
60/40
0.3
Correlation

Partial Correlation to Growth Metric

-0.2

-0.3 0.2

-0.4
0.1
-0.5
Change Surprise Combined 0.0

c. Stock-Bond Correlation
-0.1
0.3

-0.2 Treasuries
0.2
Correlation

-0.3
0.1

-0.4
0.0

-0.5
-0.1
-0.5 -0.4 -0.3 -0.2 -0.1 0.0 0.1 0.2 0.3 0.4 0.5
Inflation Growth Full Sample
Dominant Dominant Partial Correlation to Inflation Metric

Source: AQR, Bloomberg, Survey of Professional Forecasters, U.S. Bureau of Labor Statistics. Sensitivities are simple (chart a) and two-
factor partial (chart b) correlations to inflation and growth metrics described in main text. See Appendix for details of asset class proxies.

III. Exploring Real Assets

If neither stocks nor bonds will offer investors We next analyze a basket of commodities
refuge in periods of rising inflation, we look represented by the S&P GSCI Index. Here, we
to additional assets that may in Exhibit 3. see a meaningful positive inflation sensitivity.
The first is a simple proxy for U.S. real estate This stands to reason – commodities are
that combines popular listed and unlisted physical assets whose prices may be expected
indices (FTSE Nareit All REITs and NCREIF to rise in an inflationary scenario where a
Property Index respectively). This composite fiat currency (like the U.S. dollar) devalues.
has a substantial negative sensitivity to Commodity prices – including retail gasoline
inflation changes (albeit slightly milder than and food prices – are also a key input to many
equities). The resilience of a given real estate components of the CPI. It’s worth noting that
investment will depend on how easily revenues in our data sample, the most extreme episodes
can rise with inflation. But the asset class of inflation – occurring in the 1970s and
likely also shares some of equities’ exposure 1980s – were catalyzed by rising energy prices,
to the instability and risk aversion associated making it unsurprising that commodities as an
with higher inflation, as well as some bond-like asset class shows high sensitivity. While this
exposure to mortgage rates. raises the possibility that the result is specific
6 When Stock-Bond Diversification Fails: Managing inflation risk in investor portfolios | October 2021

to this sample, energy inputs remain one of the an alternative store of value in scenarios where
most volatile components of the CPI with the faith reduces in fiat currencies, also score quite
ongoing potential to drive future inflationary strongly. Of note, the broad commodity basket
episodes. An analysis of commodity has a stronger sensitivity than any individual
sub-sectors (see Appendix) finds some commodity sector, highlighting the benefits
heterogeneity across sectors, with energies of a diversified allocation, which may provide
having the strongest empirical sensitivity. protection in a broader array of inflationary
Precious metals, often cited as potentially scenarios.
attractive inflation hedges due to their role as

Exhibit 3: Historical Inflation and Growth Sensitivities of Alternative Assets 1972-2021

a. Inflation Sensitivity b. Growth and Inflation Sensitivities
0.8 0.8
0.6
Correlation

0.4 0.6
Real Estate
0.2
0.4 Equities
0.0
Partial Correlation to Growth Metric

60/40 Commodities
-0.2
Real Comm- U.S. Break- 0.2
Estate odities TIPS evens

Change Surprise Combined 0.0

c. Stock, Bond and Comm Correlations Treasuries BE

0.6 -0.2 TIPS

0.4
Correlation

0.2 -0.4
0.0
-0.2 -0.6
-0.4
Stock - Stock - Bond -
Bond Comm Comm -0.8
-0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6 0.8
Inflation Dominant Growth Dominant
Full Sample Partial Correlation to Inflation Metric

Source: AQR, Bloomberg, Survey of Professional Forecasters, U.S. Bureau of Labor Statistics. Sensitivities are simple (chart a) and two-
factor partial (chart b) correlations to inflation and growth metrics described in main text. See Appendix for details of asset class proxies.

Finally, we analyze inflation-linked bond treasury security. Given the short available
strategies including outright allocations to history for TIPS, we simulate a longer data
Treasury Inflation Protected Securities (TIPS), set using nominal bond yields and inflation
as well as an “Inflation Breakeven” (BE) forecasts so that we can perform analysis for
strategy which pairs a long TIPS position with our full data sample.13 In the analysis, TIPS
a duration-matched short position in a nominal show near zero inflation sensitivity, which

13 We subtract long-term inflation forecasts from nominal yields to get ex ante real yields, and then use these to derive synthetic implied
TIPS returns. Forecast sources are based on availability: 1972-1978, statistical estimates by Kozicki-Tinsley (2006); 1978-1989,
average of 2-3 available surveys (Hoey, Livingston, Survey of Professional Forecasters, Blue Chip Economic Indicators, Consensus
Economics); 1990-1997, Consensus Economics.
 When Stock-Bond Diversification Fails: Managing inflation risk in investor portfolios | October 2021 7

is intuitive. TIPS principal and coupon are sensitivity in all cases. For the new assets,
adjusted for inflation such that holders (to we see more heterogeneity in the inflation
maturity) are guaranteed a fixed real return dimension. Real estate sits disappointingly
that does not vary with the level of inflation close to equities, commodities and inflation
– consistent with a zero correlation. The breakevens retain their positive inflation
primary driver of shorter-term TIPS returns is sensitivity even when controlling for growth,
variation in real interest rates, to which TIPS while TIPS remains near-zero related to
have duration exposure; the empirical finding inflation. In terms of growth sensitivity, real
indicates that this variation has been unrelated estate and commodities are positively related,
to our inflation metric on average. while TIPS and BE are negatively related.

In contrast, the BE position shows a strong The study of real assets also provides an
positive correlation comparable to that of opportunity to extend the correlation analysis
commodities. Importantly, the positive from Section I to commodities. While
correlation of BE is greater than the spread commodities consistently diversify bonds
between the observations for TIPS and across environments, their diversification
nominal bonds; by hedging out real interest relative to stocks manifests most pronouncedly
rate sensitivity, the BE achieves a purer in periods when inflation news dominates; in
exposure to changes in inflation expectations. periods where growth shocks are larger (as in
the 2010s), they have a positive correlation.
As in Section I, we next explore the Economic intuition and empirical evidence
relationship to inflation conditioned on growth indicate real assets can provide good
in Panel B. Recall that for stocks, bonds diversification in inflation-dominant periods.
and 60/40, we observed negative inflation

IV. Non-Linearities and Alternative

Strategies
So far, we have reported the sensitivity of classes, scaled to 10% volatility for ease of
traditional and real assets to inflation and comparison.
growth news using linear correlation metrics.
But what if investments exhibit different Starting with traditional assets, we see that
sensitivities to upside and downside inflation while both stocks and bonds underperformed
shocks? In Exhibit 4 we display potential non- during inflationary environments as previously
linear effects by conducting a tritile sort of noted, they had differing reactions when
returns relative to the inflation environment. inflation news was negative. Bonds strongly
In particular, we separate periods when our outperformed in these environments, while
combined inflation news metric has a z-score stocks underperformed their average. The
less than -1, a z-score between -1 and 1, and a 60/40 portfolio falls in between, though also
z-score greater than 1. In each of these periods, shows mild underperformance. One possible
we report the average return for selected asset cause of the ‘frown’ pattern for stocks is that
8 When Stock-Bond Diversification Fails: Managing inflation risk in investor portfolios | October 2021

adverse growth shocks may have coincided 2. A hypothetical macro momentum strategy
with (or caused) many of the disinflationary that takes long and short positions in global
shocks in our sample. In the appendix we show macro instruments based on 12-month
upside and downside correlations controlling trends in economic variables including
for growth, and find the non-linear pattern inflation, growth, international trade,
to be weaker but still visible. This remaining monetary policy and risk sentiment.
non-linearity may be the result of an imperfect
proxy for growth, or caused by heightened Both of these strategies tend to have the
risk aversion from investors in environments opposite characteristic of stocks; they are
where the combination of economic shocks seen to benefit from inflation news in either
and policy responses has driven inflation away direction. The “convexity” property of price
from central bank targets in either direction. 14
trend following strategies with respect to equity
market outcomes has been well documented:16
For commodities and inflation breakevens, not only have these strategies been profitable
the empirical relationship appears linear, on average but a preponderance of returns
with strong outperformance in inflationary are accrued in extreme market environments.
periods and strong negative performance in Here, we see the convexity extends to
the opposite. This raises a potential concern in macroeconomic news. This characteristic
significant allocations to these assets: portfolio is also inherited by the macro momentum
losses during disinflationary adverse growth strategy which directly incorporates trends in
shocks may be exacerbated. It would therefore inflation, among other things, in forming its
be attractive to find solutions that offer positioning. An interpretation of this result is
inflation protection without other economic that environments of extreme inflation news
exposures that may compound existing and associated price reactions do not occur out
portfolio risks. of the blue; they tend to be persistent enough
that trend following strategies can pick up on
We introduce two active strategies: 15
them at some point in the cycle and position
accordingly. Conversely, in the stable inflation
1. A hypothetical trend following strategy environments in which stocks have done best,
that takes long and short positions in global these strategies have tended to underperform.
macro instruments based on trailing 1-, 3-
and 12-month price trends.

14 It is difficult to identify economic causes from our data and further study may be warranted. One potential concern with disinflationary
episodes is a loss of central bank ability to conduct traditional monetary policy due to possible lower bounds on nominal interest rates.
15 Our choice of these two, among many, alternative strategies is motivated by an economic prior on potential sensitivity to inflation,
given their ability to take meaningful directional risk to inflation sensitive assets. Other “market neutral” alternative strategies may be
expected to have limited sensitivity (see Ilmanen, Maloney and Ross, 2014), while conversely, those that load on equity or bond market
factors (like the aforementioned private equity, or long-biased credit) would be expected to inherit the sensitivity of those market
factors.
16 See for example Hurst, Ooi and Pedersen (2017).
 When Stock-Bond Diversification Fails: Managing inflation risk in investor portfolios | October 2021 9

Exhibit 4: Frowns, Smirks and Smiles - Tritile Sort of Returns Relative to Inflation
Environment 1972-2021

20%
Excess Return at 10% Volatility

15%

10%

5%

0%

-5%

-10%

-15%
U.S. Equities U.S. U.S. 60/40 Commodities Breakevens Trend Macro Mom
Treasuries

Downside surprise Stable Upside surprise

Source: AQR, Bloomberg, Survey of Professional Forecasters, U.S. Bureau of Labor Statistics. Downside and upside surprise periods are
defined as periods when inflation news metric has z-score <-1 and >1 respectively, with the rest of the sample categorized as stable. See
Appendix for proxies and construction of hypothetical portfolios. Hypothetical performance results have certain inherent limitations, some
of which are disclosed in the Appendix.

V. Putting It All Together

So far, we have seen that both components of cost over the long term.17 This may still be an
traditional stock-bond portfolios have tended to attractive option, particularly if the objective
underperform when inflation rises, indicating is to implement a tactical “trade” on inflation
a concentrated exposure to upside inflation based on a shorter-term view.
shocks. We also presented several “real assets”
and active strategies that had the opposite A different approach is to seek to improve
characteristic and tended to outperform in macroeconomic diversification across
these periods. How should investors holding compensated return sources. From this
predominantly stock-bond portfolios consider perspective, commodities may be an attractive
allocating to these additional assets? It allocation given the combination of positive
depends on the objective. If the focus is simply inflation exposure with a long-term positive
to address upside inflation risk, they may risk premium. This is consistent with “risk
choose an allocation to the purest hedge: parity” approaches where equity, bond and
inflation breakevens. In doing so, they should commodity allocations are typically given
recognize that this allocation, while helping equal prominence in portfolio construction.
address inflation concerns, might incur a Our analysis (not reported here) confirms that

17 Investors may be expected to pay to hedge or insure against inflation risk, assuming there is a positive inflation risk premium. This may
be offset to some extent by a (time-varying) liquidity premium due to the lower liquidity of TIPS relative to their nominal counterparts.
10 When Stock-Bond Diversification Fails: Managing inflation risk in investor portfolios | October 2021

a risk parity portfolio may be more resilient to 10% or 20% to this new portfolio (Exhibit
inflation shocks.18 5), though of course investors may choose
individual components most suited to their
Lastly, an investor may seek to dilute portfolio objectives.
macroeconomic exposures via allocations
that hedge such exposures, such as market- As expected, we find that the hypothetical real
neutral alternatives, or strategies exhibiting return portfolio has a large positive inflation
positive exposure to economic extremes, such sensitivity – a correlation to our inflation
as the trend and macro momentum strategies metric of near 0.7 – with or without the
described in this paper. growth control variable. Thus, even moderate
allocations to this hypothetical portfolio can
We take a balanced approach by creating a reduce the negative correlation of 60/40 to near
“simple real return” strategy with a 25% risk zero. A 20% allocation shifts the correlation
allocation to each of inflation breakevens, from -0.27 to -0.05 (from highly statistically
commodities, trend, and macro momentum. significant to insignificant). In our tritile
We compare the results for this portfolio, along sort, we see that the tendency of 60/40 to
the dimensions previously considered, with underperform in inflationary environments is
those of the traditional 60/40 portfolio, and ameliorated meaningfully by an allocation to
portfolios that start with 60/40 and allocate this real return portfolio.

Exhibit 5: Impact of ‘Real Return’ Allocation on Historical Inflation Sensitivities 1972-2021

a. Inflation Sensitivities b. Growth and Inflation Sensitivities

0.8 0.5
0.6 +20%
0.4
Partial Corerlation to Growth

60/40 RR
0.4
Correlation

0.3
0.2
0.2 +10%
0.0
RR
-0.2 0.1
Metric

-0.4 0.0
Hypothetical U.S. 90% 80% -0.1
Simple 60/40 60/40, 60/40,
-0.2
Real 10% 20%
-0.3
Return Hypo. Hypo.
Simple Simple -0.4
Real Real -0.5
Return Return -0.5 -0.3 -0.1 0.1 0.3 0.5

Change Surprise Combined Partial Correlation to Inflation Metric

18 Risk parity typically includes larger nominal bond exposure than 60/40, but also introduces commodities. The inflation sensitivities
of these two differences are offsetting. But in aggregate, we find risk parity to be the more resilient across both growth and inflation
regimes.
 When Stock-Bond Diversification Fails: Managing inflation risk in investor portfolios | October 2021 11

c. Tritile Sort of Return by Inflation Environment

20%
Excess Return at 10% Volatility

15%

10%

5%

0%

-5%
Hypothetical Simple U.S. 60/40 90% 60/40, 10% Hypo. 80% 60/40, 20% Hypo.
Real Return Simple Real Return Simple Real Return

Downside surprise Stable Upside surprise

Source: AQR, Bloomberg, Survey of Professional Forecasters, U.S. Bureau of Labor Statistics. Sensitivities are simple (chart a) and
two-factor partial (chart c) correlations to inflation and growth metrics described in main text. ‘RR’ is hypothetical simple real return as
defined above. Downside and upside surprise periods (chart c) are defined as periods when inflation news metric has z-score <-1 and >1
respectively, with the rest of the sample categorized as stable. See Appendix for proxies and construction of hypothetical portfolios.
Hypothetical performance results have certain inherent limitations, some of which are disclosed in the Appendix.

VI. Conclusion
Recent economic events have increased commodities and inflation breakevens, have
concerns around the potential for meaningful positive inflation sensitivity,
unexpectedly high inflation – a scenario though real estate and unhedged TIPS show
that our empirical analysis suggests may be negative and near-zero inflation correlations
challenging for stock-bond portfolios. Not only respectively. In addition, active strategies such
are such portfolios concentrated in terms of as trend following and macro momentum
asset exposures, with equity risk dominating, show positive convexity to the inflation
but also in terms of inflation exposure, with environment, i.e., the opposite characteristic to
both components tending to have worse-than- that of equities.
average returns during inflationary outcomes.
In the case of bonds, this exposure has been Allocations to a diversified combination of
linearly negative, while equities show some commodities, inflation breakevens, global
tendency to underperform during falling macro, and trend following can thus help
inflation periods as well. meaningfully to offset a traditional portfolio’s
concentrated exposure to inflation.
By studying alternative assets we can identify
potential solutions. Some real assets, notably
12 When Stock-Bond Diversification Fails: Managing inflation risk in investor portfolios | October 2021

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 When Stock-Bond Diversification Fails: Managing inflation risk in investor portfolios | October 2021 13

Appendix

Inflation Sensitivities for Additional market equities. Unhedged international

Assets and Sectors equities have tended to offer more resilience
when inflation rises, partly because episodes of
Exhibit A1 Panel A shows inflation sensitivities domestic inflation tend to put pressure on the
for 11 U.S. equity sectors. While the broad local currency. International assets may be less
market has a negative sensitivity, the sectors helpful in the case of a global inflation shock.
show considerable variation. The energy sector
stands out as having thrived in times of rising Panel C shows sensitivities for commodity
inflation, while real estate, materials and sub-sectors and portfolios. Broad portfolios
industrials have shown more resilience than (whether equal- or production-weighted) have
other sectors. The most vulnerable sectors sensitivities as high as, or higher than, the
have been consumer staples (often considered highest individual sector, as well as having
bond-like) and consumer discretionary, where earned substantially higher risk-adjusted
eroding purchasing power may hit hardest. returns than narrower sector investments over
the long term (see Levine et al., 2018).
Panel B compares inflation sensitivities of U.S.
equities and unhedged non-U.S. developed

Exhibit A1: Inflation Sensitivities for Additional Assets and Sectors

a. U.S. Equity Sectors 1974-2021
0.5
0.4
0.3
0.2
Correlation

0.1
0.0
-0.1
-0.2
-0.3
Consumer Consumer Financials Comm. Health Utilities Info. Industrials Materials Real Energy
Staples Disc. Serv. Care Tech. Estate

b. U.S. and Non-U.S. c. Commodity Sectors and Portfolios 1972-2021

Equities 1972-2021

0.0 0.7
0.6
Correlation

-0.1 0.5
Correlation

0.4
-0.2 0.3
0.2
-0.3 0.1
U.S. Equities Non-U.S. 0.0
Equities Livestock Base Softs Precious Grains Energies Eq-wtd GSCI
Unhedged Metals Metals Comms

Source: AQR, Bloomberg, Survey of Professional Forecasters, U.S. Bureau of Labor Statistics. Sensitivities are simple correlations to
inflation metric described in main text. Base metals data start only in 1977, energies in 1983. See Appendix for details of asset class
proxies.
14 When Stock-Bond Diversification Fails: Managing inflation risk in investor portfolios | October 2021

Testing for Non-Linear Inflation positive inflation news (top row) and negative
Sensitivities After Controlling for news (bottom row). The color indicates the
Growth sign: green means the investment has seen
outperformance associated with news of
To complement the tritile analysis in the main that sign, while red means it has tended to
article, we also conduct an upside/downside underperform. Where an investment has two
correlation analysis that controls for growth green or two red bubbles, this indicates a non-
exposure. We divide our 50-year sample into linear sensitivity to inflation after controlling
two sub-samples based on the sign of our for growth. The chart confirms that equity
combined inflation metric, and compute sensitivity retains some non-linearity (negative
partial correlations to inflation and growth convexity) after controlling for growth (see
metrics in each sub-sample. The bubbles in main article), and also that trend and macro
Exhibit A2 indicate the magnitudes of partial momentum strategies retain their valuable
correlations to inflation in the periods of positive convexity.

Exhibit A2: Upside and Downside Inflation Sensitivities 1972-2021

Upside Surprises

0.34 0.41 0.30 0.50 0.65 0.53 0.17 0.75

Equities and
60/40 harmed by Bonds, Trend and macro
surprises in both commodities and momentum benefit
directions (but BE show linear from upside and
Downside Surprises

more exposure to patterns downside surprises

upside)

0.13 0.07 0.13

0.30 0.34 0.36 0.29 0.20

U.S. U.S. U.S. Commodities Break- Trend Macro Hypo. Simple

Equities 60/40 Treasuries evens Momentum Real Return

Size of bubble shows

Benefits from surprises Harmed by surprises strength of sensitivity (correlation)

Source: AQR, Bloomberg, Survey of Professional Forecasters, U.S. Bureau of Labor Statistics. Sample divided into positive and negative
inflation metric sub-samples, then for quarterly overlapping 1-year asset returns partial correlations are computed to contemporaneous
inflation and growth metrics. Partial correlations to inflation reported in chart. See Appendix for proxies and construction of hypothetical
portfolios. Hypothetical performance results have certain inherent limitations, some of which are disclosed in the Appendix.
 When Stock-Bond Diversification Fails: Managing inflation risk in investor portfolios | October 2021 15

Asset Class Proxies for Inflation Sensitivity Analysis

Investment Proxy Source

U.S. Equities MSCI U.S. Net TR Index Bloomberg

Non-U.S. MSCI World ex U.S. Net TR Unhedged Index Bloomberg

Equities

U.S. Treasuries 10-year U.S. Treasury GFD

U.S. 60/40 60% U.S. Equities, 40% U.S. Treasuries as defined above Bloomberg,
GFD

B/E Inflation Long 10-year U.S. TIPS, short 10-year U.S. Treasury Bloomberg,
GFD

U.S. TIPS From 1997, U.S. 10-year TIPS. Before 1997, synthetic returns based on Bloomberg
nominal Treasury yields and survey-based expected inflation.

Real Estate 50% FTSE Nareit All REITs Index (listed), 50% NCREIF Property Index Bloomberg
(unlisted)

Commodities S&P GSCI Total Return Index Bloomberg

Trend Following Hypothetical trend following strategy as described in A Century of Evidence AQR
on Trend-Following Investing by Hurst, Ooi and Pedersen (2017). The
strategy goes long markets that have been rising and going short markets
that have been falling, betting that those trends over the examined look-
back periods will continue. The strategy was constructed with an equal-
weighted combination of 1-month, 3-month, and 12-month trend-following
strategies for 67 markets across 4 major asset classes: 29 commodities, 11
equity indices, 15 bond markets, and 12 currency pairs. Returns are net of
estimated transaction costs and 2 & 20 fees.

Macro Hypothetical long/short and directional strategies applied to 15 equity AQR

Momentum indices, 9 government bond markets, and 9 currencies, with signals based
on the following macro momentum themes as described in A Half Century
of Macro Momentum by Brooks (2017): Business Cycle, International Trade,
Monetary Policy, Risk Sentiment. The strategy goes long assets for which
fundamental momentum is favorable and short assets for which it is
unfavorable. Returns are net of estimated transaction costs and 2 & 20
fees.

Note: All asset class proxies and 60/40 are presented gross of transaction costs and fees.
16 When Stock-Bond Diversification Fails: Managing inflation risk in investor portfolios | October 2021

Disclosures
Important Disclosures

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Index Definitions:
The MSCI U.S. Index is a free float-adjusted market capitalization index that is designed to measure the performance large and mid cap
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The MSCI World ex U.S. Index is a free float-adjusted market capitalization index that is designed to measure the large and mid cap equity
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The FTSE Nareit All REITs Index is a market capitalization-weighted index that and includes all tax-qualified real estate investment trusts
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The NCREIF Property Index measures the performance of real estate investments on a quarterly basis and evaluates the rate of returns in the
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 When Stock-Bond Diversification Fails: Managing inflation risk in investor portfolios | October 2021 17

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HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH, BUT NOT ALL, ARE DESCRIBED
HEREIN. NO REPRESENTATION IS BEING MADE THAT ANY FUND OR ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR
LOSSES SIMILAR TO THOSE SHOWN HEREIN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL
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OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT
OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING
RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO
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POINTS THAT CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO
THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM, WHICH CANNOT BE FULLY
ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS, ALL OF WHICH CAN ADVERSELY AFFECT
ACTUAL TRADING RESULTS. The hypothetical performance results contained herein represent the application of the quantitative models
as currently in effect on the date first written above, and there can be no assurance that the models will remain the same in the future or that
an application of the current models in the future will produce similar results because the relevant market and economic conditions that
prevailed during the hypothetical performance period will not necessarily recur. Discounting factors may be applied to reduce suspected
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impact on the hypothetical returns presented. Actual advisory fees for products offering this strategy may vary.

There is a risk of substantial loss associated with trading commodities, futures, options, derivatives, and other financial instruments. Before
trading, investors should carefully consider their financial position and risk tolerance to determine whether the proposed trading style is
appropriate. Investors should realize that when trading futures, commodities, options, derivatives, and other financial instruments,
one could lose the full balance of their account. It is also possible to lose more than the initial deposit when trading derivatives or using
leverage.

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