Rethinking the 60/40 in an Inflationary Environment: Regime-Dependent Asset-Inflation Sensitivities and Portfolio Construction Implications

Abstract

The recent resurgence of inflation has reignited concerns about portfolio vulnerability, challenging long-held assumptions about diversification and risk. This thesis investigates how asset classes respond to different inflation measures and whether the traditional 60/40 equity–bond portfolio can be improved through targeted diversification. Using bivariate regression across multiple inflation regimes and impulse response functions, the study finds that inflation-hedging properties are highly inflation- and regime-dependent. Some assets, like commodities and inflation-linked bonds, hedge headline inflation effectively, while equities and nominal bonds tend to suffer. Several assets hedge inflation only in certain regimes, highlighting the importance of macroeconomic context. The 60/40 portfolio proves especially vulnerable in inflationary environments, as stock–bond correlations rise, reducing diversification benefits. This vulnerability can be mitigated by incorporating inflation-sensitive assets, which improve drawdown resilience and tail-risk protection. A dynamic allocation strategy, shifting exposure from bonds to inflation hedges based on the stock–bond correlation, performs particularly well in inflationary periods with limited overall efficiency loss. Leverage overlays added little benefit, underscoring that effective protection requires thoughtful reallocation rather than mechanical enhancements. The most resilient portfolios actively reduced bond exposure in favor of assets with favorable inflation traits. This thesis offers practical insights into building more inflation-resilient portfolios and provides a foundation for future re- search on indicator-driven allocation strategies.