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With inflation rates remaining close to zero in all major developed economies for long periods of time, especially from 1998 - 2015, investors have become increasingly concerned about the potential effects of deflation on asset value. Negative inflation rates were observed between 1998 and 2009 in Hong Kong and Japan, and those economies faced several years of deflation. There is a rich body of literature on the effects of inflation hedging on the returns of stocks, bonds, and real estate. We examine asset returns for these products between 1986 and 2009, and use an ARIMA model to explore whether they offer a deflation hedge. We show that rents and real estate prices are closely linked to consumer prices, which confirms previous findings on inflation hedging. Since the relationship is generally positive and over proportional, we find that real estate is not an effective hedge against deflation. In contrast, we find no relationships between stocks or bonds and inflation. Only for Japanese bonds are we able to find a significantly negative relationship with unexpected deflation.

Focusing on the role of the investment horizon, we analyze the inflation-hedging abilities of stocks, bonds, cash and direct commercial real estate investments. Based on vector autoregressions for the UK market we find that the inflation-hedging abilities of all assets improve with the investment horizon. For long horizons, real estate seems to hedge unexpected inflation as well as cash. This has implications for the difference between the return volatility of real returns versus the return volatility of nominal returns, and ultimately for portfolio choice. Portfolio optimizations based on real returns yield higher allocations to cash and real estate than optimizations based on nominal returns. Bonds tend to be less attractive for an investor taking into account inflation. Switching from nominal to real returns, the allocation to stocks is decreasing at medium investment horizon, but increasing at long horizons.

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