Final answer:
The correct relationship between asset class returns and expected inflation is most likely D. Cash and Bonds produce low returns because they do not keep up with inflation, whereas Equity and Real Estate generally offer high returns as they can potentially outrun inflation.
Step-by-step explanation:
The question posed regards the relationship between various asset class returns and inflation when it is within expectations. In such scenarios, different asset classes are likely to perform as follows:
- Cash: Typically provides a low rate of return, especially in inflationary environments, because the interest earned doesn't often keep pace with the rate of inflation, resulting in a negative real rate of return.
- Bonds: Inflation expectations are usually factored into the bond yields. Moderate inflation can lead to moderate returns, but unexpected high inflation can lead to low or negative real returns due to fixed interest payments being eroded by inflation.
- Equity: Can offer high returns since many companies have the ability to pass on inflation to consumers through price increases, and thus can potentially generate earnings that keep pace with or exceed inflation.
- Real Estate: Often considered a good hedge against inflation, as property values and rental income have the potential to rise with inflation leading to high returns.
Based on these characteristics, the answer to the students' asset class and returns question during periods of expected inflation is D. Cash: Low, Bonds: Low, Equity: High, Real Estate: High. We must also consider the risk and liquidity aspects while analyzing various forms of investment. Typically, lower-risk investments like bank accounts offer lower expected returns, whereas higher-risk investments like stocks may provide higher expected returns.
Moreover, inflation can erode the purchasing power of cash, which is why holding large amounts of cash during inflationary periods can lead to losses in real terms.