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All Asset All Access

All Asset All Access: Investment Implications of Inflation Expectations

Research Affiliates discusses the outlook for U.S. inflation expectations, and explains their business cycle model and how it informs portfolio positions.

In this edition, Rob Arnott, chairman of Research Affiliates, shares his views on U.S. inflation expectations and explains why changes in inflation expectation levels are important when considering the return prospects of the All Asset strategies. Omid Shakernia, senior vice president of the multi-asset strategies team at Research Affiliates, delves into the business cycle model of the All Asset strategies and shares how that model, along with other tactical signals, informs the positioning of the All Asset strategies. As always, their insights represent Research Affiliates’ views in the context of the PIMCO All Asset and All Asset All Authority funds. All Asset All Access is published quarterly.

Q: Why do you think U.S. inflation expectations will continue to rise in the near term?

Arnott: The price of anything is a matter of supply and demand. When people stop spending for a few months, for example because of pandemic lockdowns, and their bank accounts are supplemented by stimulus checks (whether they need the money or not), demand would be expected to go up. A jeweler friend of mine calls it “The Itch.” If supply chain disruptions constrict supply, and people choose to stay home and not work (whether because generous benefits make this possible or because they are concerned about the risks of the pandemic), supplies would be expected to shrink. These forces in turn should tend to push up prices of consumer goods, services, and financial assets. As Ben Graham famously opined in the 1940s, the stock market is a weighing machine in the long run and a voting machine in the short run. Liquidity forces, paired with simple supply and demand, tend to allow inflation to spill over into financial assets.

One key component is shelter. At nearly one-third of the CPI (U.S. Consumer Price Index, compiled by the Bureau of Labor Statistics or BLS), shelter has the biggest weight in this basket of goods and services. What is a primary driver of shelter inflation? The rental market, though it tends not to be as straightforward as it might seem. There are three components:

  • Actual rent paid by renters is the most basic, but it’s sticky. Over the last year, CPI shows rents up 2.4% (as of September), while surveys (such as Zumper) show that rents are up 12% in the last year. Why the roughly 1000 basis point (bp) difference? Many rental agreements are multiyear, and many may not have come up for renewal and therefore may have not yet registered that 12% hike.
  • Owners’ equivalent rent (OER), which is nearly one-fourth of current CPI, is even more problematic. To determine OER’s weight in CPI, the BLS asks thousands of homeowners what they think their home would rent for. The average homeowner doesn’t usually ponder or research this question, so it’s basically guesswork. Naturally, people have a tendency to anchor on their previous answer and not revise their expectations up or down materially until after meaningful changes in rents and home prices are self-evident. The BLS updates the implicit rent data for each home in its survey sample every six months to calculate OER, which as of September 2021 was up 2.4% (annualized) over the last year. Over the same time frame, rents were up 12% and home prices were up 18% (the latter according to the S&P CoreLogic Case-Shiller U.S. National Home Price Index).
  • The third component of shelter inflation is “lodging away from home,” which is usually dominated by hotel and motel prices. This is the only part of the shelter inflation measure that typically doesn’t have severe problems with lags and smoothing. It’s up 17.5% in the past year, according to CPI (as of September).

Going back to 1988, U.S. home price inflation (using the Case-Shiller index – see Figure 1) has only a 17% correlation with concurrent OER, but has a 67% correlation with the next year’s OER, according to Research Affiliates calculations. Research Affiliates’ regression analyses indicate the one-year lagged Case-Shiller house price inflation has a much stronger relationship with OER than do other concurrent economic or market variables.

Figure 1 is a line chart spanning January 2000 through September 2021, with select forecasts through September 2022. The data models potential changes in U.S. owners’ equivalent rent (OER), which is a component of the U.S. Consumer Price Index, noting how changes in OER historically have tended to lag changes in U.S. home prices. Research Affiliates’ modeled OER forecast suggests a potential rise in annualized OER above 4% in 2022. Measures of actual OER, home prices, and concurrent CPI were also elevated in 2021.

In other words, Research Affiliates expects the 18% rise in U.S. home prices over the last 12 months will likely affect the next year’s rise in OER. Because home prices are so volatile, the data has a small statistical coefficient of 0.12, which carries forward for three years. So, the recent 18% rise in Case-Shiller home prices suggests an estimated boost in OER inflation of 2.2% in each of the next three years, or 6.6% in total. Research Affiliates’ analysis suggests that OER will accelerate above 5% by mid-2022, potentially continuing higher from there. In Research Affiliates’ view, it may be difficult for U.S. inflation to be “transitory” against this headwind.

Q: Why is a change in inflation expectations important when considering the return prospects of the All Asset strategies?

Arnott: The All Asset strategies are intended to maximize real return, consistent with preservation of real capital and prudent investment management – that is, they seek to mitigate the impact of inflation. By emphasizing asset classes with high correlations to changes in inflation, these strategies are designed and managed to complement allocations to mainstream stocks and bonds, in Research Affiliates’ view, both of which could fare badly if inflation rises.

One of the notable traits of the All Asset strategies has been the historical tendency of their returns to correlate with changes in inflation expectations (see Figure 2). Since the All Asset Fund’s inception in July 2002, there has been an 83% correlation between the fund’s returns and movements in the 10-year U.S. breakeven inflation rate (over 12 month periods). On average since inception, each 0.1% rise in inflation expectations has historically corresponded to 1.63% in returns for the All Asset Fund and 1.54% for the All Asset All Authority Fund (returns are for institutional shares, net of fees).

Figure 2 is a scatter plot chart, with the Y axis depicting concurrent 12-month returns (Institutional shares, net of fees) since inception of the PIMCO All Asset Fund and PIMCO All Asset All Authority Fund, and the X axis depicting 12-month changes in 10-year U.S. breakeven inflation. As discussed in the text preceding the chart, fund returns have historically correlated relatively closely with BEI, with an 83% correlation over the time frame for All Asset Fund, and a 77% correlation for All Asset All Authority.

This table lists net-of-fees performance for Institutional shares of the PIMCO All Asset Fund and PIMCO All Asset All Authority Fund as of 30 September 2021 over one-, three-, five-, and ten-year and since inception time frames. Benchmark performance is also included. Data is listed within the table, with explanatory notes below.

For the most recent quarter-end performance data for the All Asset and All Authority funds, please click on the link below:

U.S. inflation expectations have rebounded from a trough of 0.9% at end-March 2020 to 2.4% as of end-September 2021. Over that same time horizon, the All Asset Fund delivered a cumulative return of 44.62% and the All Asset All Authority Fund delivered 45.22% (institutional shares, net of fees for both funds), outpacing the conventional 60/40 balanced portfolio by over 460 bps for All Asset, and over 525 bps for All Authority. (The 60/40 portfolio reflects a 60% allocation to the S&P 500 and a 40% exposure to the Bloomberg U.S. Bond Aggregate Index.)

Q: How does Research Affiliates’ business cycle modeling inform asset allocation decisions within the All Asset strategies?

Shakernia: While asset class yields and valuations historically have tended to be predictors of long-term returns, the business cycle tends to influence returns over shorter horizons. When macroeconomic conditions deteriorate, investors have often demanded higher discounts on risk assets, contributing to typically lower valuations. That is, we generally have seen lower prices and higher risk premiums in “bad times” when consumption, output, and investment are low, and unemployment is high.

Research Affiliates’ global business cycle model incorporates select country-specific economic activity and monetary policy indicators to forecast the probability of an economic slowdown across developed and emerging markets. The forecasted likelihoods of economic slowdown are then mapped to Research Affiliates’ short-horizon return estimates for asset classes based on each class’s perceived sensitivity to the business cycle. Finally, these business cycle signals are mapped to portfolio tilts to potentially tactically favor procyclical versus countercyclical asset classes across the All Asset suite’s global opportunity set.

Q: What is Research Affiliates’ business cycle model saying today?

Shakernia: Research Affiliates’ model today estimates that the probabilities of slowdown in U.S. and developed ex U.S. markets are at decade lows, indicating a likely probability of continued above-trend growth potential in the coming months (see Figure 3). This decline in slowdown probability over the past year is consistent with the economic growth driven in part by the substantial fiscal stimulus response to the COVID-19 pandemic. In contrast, the slowdown probability across emerging market (EM) countries has inched up over the past year to “neutral territory.” Research Affiliates’ model’s diverging slowdown probabilities between developed and emerging economies is consistent with what the International Monetary Fund has called “fault lines in the global recovery,” attributing the divergence to differences in policy support and vaccine availability.

Figure 3 is a three-part line chart depicting Research Affiliates’ business cycle model for three regions – the U.S., developed markets ex U.S., and emerging markets – over the time frame of January 2000 through September 2021. As discussed in the text prior to the chart, while the model indicates the probability of recession in the U.S. and other developed markets is approximately 25%, in emerging markets, the probability is just under 50%. A brief description of the model is included below the chart.

Q: Along with the business cycle model, what other signals inform shorter-horizon portfolio tilts within the All Asset strategies?

Shakernia: One of Research Affiliates’ latest enhancements to informing the All Asset investment process is the inclusion of new shorter-horizon tactical signals that complement All Asset’s structural orientation as a contrarian, value-oriented strategy anchored on the expectation of long-horizon mean reversion. Currently, we focus on five tactical signals:

  • Short-term momentum: Trending markets can be indicative of short-term under-reaction to news, time-varying risk tolerance, and compensation for crash risk.
  • Long-term reversal: Reverting markets may act as compensation for bearing contrarian positions.
  • Volatility: Heightened volatility can be indicative of dislocation opportunities, while subdued volatility can be indicative of continued upward-trending prices.
  • Sharpe ratio: Elevated risk-adjusted returns can be indicative of resistance to mean reversion, while subdued risk-adjusted returns can be indicative of a likely reversal.
  • Momentum turning points: Slow and fast momentum agreement/disagreement can lead to changes in our conditional return estimates that potentially can be harvested after turning points.

These tactical signals are based on an original relative value “pairs trading” framework developed by my colleagues, Cam Harvey, Christian Goulding, and Alex Pickard. Notably, the research findings suggest that these signals have tended to be lightly correlated with each other, which may be favorable, and that their inclusion into a portfolio may provide attractive incremental return potential while potentially reducing the average equity beta. Figure 4 illustrates the current portfolio tilts suggested by blending the output of the five tactical signals, which in aggregate suggest a modest incrementally procyclical posture.

Figure 4 is a bar chart depicting Research Affiliates’ views on shorter-horizon portfolio tilts for various asset classes as suggested by tactical signals, as discussed in the text prior to the chart. As of 30 September 2021, the greatest underweight tilts are indicated for emerging market equities, short-term bonds, and (to a lesser degree) global core bonds, while the greatest overweight tilts are indicated for large U.S. equities, and (to a lesser degree) real estate investment trusts and commodities. Asset class proxies are detailed below the chart.

The All Asset strategies represent a joint effort between PIMCO and Research Affiliates. PIMCO provides the broad range of underlying strategies – spanning global stocks, global bonds, commodities, real estate, and liquid alternative strategies – each actively managed to maximize potential alpha. Research Affiliates, an investment advisory firm founded in 2002 by Rob Arnott and a global leader in asset allocation, serves as the subadvisor responsible for the asset allocation decisions. Research Affiliates uses their deep research focus to develop a series of value-oriented, contrarian models that determine the appropriate mix of underlying PIMCO strategies in seeking All Asset’s return and risk goals.


1 “Fault Lines Widen in the Global Recovery,” IMF World Economic Outlook, July 2021.

2 Christian L. Goulding, Campbell R. Harvey, and Alex Pickard, “Decoding Systematic Relative Investing: A Pairs Approach” (December 2020), SSRN no. 3680314

The Author

Robert Arnott

Founder and Chairman, Research Affiliates

Omid Shakernia

Multi-Asset Strategies, Research Affiliates

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A word about risk: The PIMCO All Asset Fund and the PIMCO All Asset All Authority Fund invests in other PIMCO funds and performance is subject to underlying investment weightings which will vary. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be appropriate for all investors. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee there is no assurance that private guarantors will meet their obligations. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Investing in securities of smaller companies tends to be more volatile and less liquid than securities of larger companies. Inflation-linked bonds (ILBs) issued by a government are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Derivatives and commodity-linked derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Commodity-linked derivative instruments may involve additional costs and risks such as changes in commodity index volatility or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Investing in derivatives could lose more than the amount invested. The cost of investing in the Funds will generally be higher than the cost of investing in a fund that invests directly in individual stocks and bonds. The Funds are non-diversified, which means that it may invest its assets in a smaller number of issuers than a diversified fund.

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Alpha is a measure of performance on a risk-adjusted basis calculated by comparing the volatility (price risk) of a portfolio vs. its risk-adjusted performance to a benchmark index; the excess return relative to the benchmark is alpha. Beta is a measure of price sensitivity to market movements. Market beta is 1. Breakeven inflation rate (or expectation) is a market-based measure of expected inflation or the difference between the yield of a nominal and an inflation-linked bond of the same maturity.

Bloomberg U.S. TIPS: 1-10 Year Index is an unmanaged market index comprised of U.S. Treasury Inflation-Protected Securities having a maturity of at least 1 year and less than 10 years. Bloomberg U.S. TIPS Index is an unmanaged market index comprised of all U.S. Treasury Inflation-Protected Securities rated investment grade (Baa3 or better), have at least one year to final maturity, and at least $500 million par amount outstanding. CPI + 500 and CPI + 650 Basis Points benchmarks are created by adding 5% or 6.5% to the annual percentage change in the Consumer Price Index (CPI). This index reflects seasonally adjusted returns. The Consumer Price Index is an unmanaged index representing the rate of inflation of the U.S. consumer prices as determined by the U.S. Bureau of Labor Statistics. There can be no guarantee that the CPI or other indexes will reflect the exact level of inflation at any given time. It is not possible to invest directly in an unmanaged index.

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