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Alternative Asset Allocation for Hedging Inflation

Perspectives from History, Music, and Macroeconomics

Dec 20, 2021

For experienced and institutional investors, outpacing inflation has been top of mind lately. In the following article, we will review alternative asset allocation strategies for volatile markets.

Storied Inflation

Inflation typically reaches a crescendo before reorienting consumers to spend less on non-essential goods and services. In response to reduced spending, economic volume and overall performance temper. But that’s only part of the story.

Institutional investors often anticipate this behavior because it tends to happen in cycles; lately, something has been offbeat.

At the end of 2021, we live in a world punctuated by inflation and divergent expectations. Like a game of musical chairs interrupted by the scratching of a record, our macroeconomic cycle has lost its cadence. This punctuation affects everyday life and investment plans for the future. More pointedly, it reorients institutional investors to favor alternative assets as potential inflation hedges.

Preparing for Inflation

When the record scratches, it’s time to rearrange the chairs and focus on investments marked by their uniqueness and a low correlation to other asset classes.

Allocating capital to low-correlation assets has historically helped investors weather inflationary storms. This conservative strategy often includes an allocation to U.S. bonds, treasuries, and other fixed-interest instruments to balance out riskier investments elsewhere. While fixed-interest investments usually occupy 40% of a balanced portfolio, times are changing.

Stalled Logic

Using bonds to generate passive income has helped investors achieve risk-adjusted returns for hundreds of years. The logic behind a 60/40 equity-bond blend is that earning fixed-interest income will help offset volatility in the face of unanticipated economic outcomes. For instance, when inflation spikes bond yields typically follow suit, providing earnings potential which may have otherwise depreciated.

But bonds are losing their ballast.

The sheer volume of cash, record low interest rates, and a strong dollar have diminished the value proposition of fixed-interest investments like bonds and 10-year Treasury notes, which currently yield less than 1.5%.

With inflation reaching 6.8% in Q4 2021, the other 60% of investors’ assets need to outperform fixed-interest investments to achieve meaningful returns. Bond yields faltering despite inflation indicates that the logic behind this bellwether asset allocation may be stalling out. As a result, investors will look to both low-correlation and risk assets to close the delta between low yields and high inflation.

Persisting Inflation

When transitory inflation persists, sophisticated investors look out the risk curve to outpace the hidden costs of currency devaluation. Investors saw this scenario play out in late 2021 when markets shot higher as a risk-on sentiment returned in the face of the Covid-19 Omicron variant.

What has been slightly more difficult to see is how alternatives perform under pressure. This is largely because private companies have different reporting standards than public companies. Recent technological advances like digital asset securitization have enabled investors to gain greater insight into private markets. As digital-first issuance increases transparency across the entire trade cycle, investors will continue to attain valuable insight into real-time price action.

Gleaning Value

Private markets have long offered accredited and institutional investors exposure to alternatives, outperforming the S&P 500 by more than 70%,1 and growing twice as fast as public equities.2 Securitize makes gauging alternative asset performance simple with an easy-to-read dashboard featuring real-time tokenized fund insights.

In late 2021, we saw an uptick in low-correlation assets like wine, whisky, and art.

For investors looking for the best of both worlds, digital assets like bitcoin feature risk-on attributes with long-term inflation hedge potential while digital asset securities provide low-correlation exposure to alternative assets like commodities and real estate.3 When combined, investors can achieve balanced risk, reward, and performance insights.

Given its blistering 12-year upward trajectory and recent public market accessibility, many will consider allocating capital to digital assets like bitcoin for the first time in 2022.

Realizing Potential

The responsibility of central banks and fiscal authorities around the world is to keep their economy on track through good times and bad. In situations of deficit overheating, central banks will typically cool the economy by raising interest rates, bringing inflation down over time. With new unemployment claims nearing pre-pandemic lows and the Federal Reserve recently pulling rate hikes forward into 2022 and 2023, we can expect some moderation moving forward.

When inflation soars, another way the macroeconomic cycle gets back on track is by bringing down the cost of labor through technological innovation. In this scenario, economies move down and to the right on the BBNN model of economic disequilibrium, increasing domestic aggregate demand and pulling the labor market into a new state of normalcy with inflation-adjusted wages. This technology-driven change also affects markets.

Emerging technologies like blockchain and distributed computing systems are beginning to make significant impacts on the global economy, already facilitating more efficient trading for oil and gas, real estate, and digital assets.

And now blockchain technology is helping wealth management realize even greater potential with new digital asset security offerings like the S&P’s first-ever tokenized fund to track digital assets, the Securitize S&P Cryptocurrency Large Cap Ex Mega Tokenized Fund.4 Using blockchain technology enables this new financial instrument to provide investors with an efficient and economical investment experience, something with which legacy financial infrastructure often struggles.

Moving Forward

What might this change look like moving forward?

Due to their limited supply and persistent demand, digital assets like bitcoin have inflation hedge potential. As more institutions’ expressed interest in digital assets and digital asset securities is realized, the emerging asset class will mature in value and utility. Yield earning potential for bitcoin will supplement dividends in a balanced portfolio and start to reduce the common reliance on bonds as an inflation hedge.

This change is not inevitable. It is one of many outcomes. The way history is shaping up, however, seems to be nudging the record back on track, pulling economies ahead as we settle back into a world rapidly accelerated by technological innovation. Investors should take note and allocate accordingly.5

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