Seven ways to think about inflation

There’s been no shortage of sensational headlines regarding the topic of inflation in recent weeks. A quick check on Google Trends is a great quantification of the drastic increase in attention being paid to the topic.

Source: google trends search for “inflation”

How does this sudden attention relate to a portfolio that’s diversified across multiple asset classes? We set out to share the answers to this question in seven concise bullets.

1. It’s unpredictable – Phillip Tetlock of UPenn has dedicated a significant portion of his career to studying the prediction accuracy of experts in politics and economics. The punchline is by and large experts are not great forecasters. The SSGA chart below is a salient example as it pertains to inflation forecasting.

   

2. The denominator effect – At least part of the reason we’ve seen a recent spike in inflation is attributed to the “denominator effect.” The most common expression of inflation is the year-over-year change. Given the fact that 12 months ago we were experiencing a recession and a flat lining in CPI, one could easily assume that we were eventually in line for a sharp increase in CPI data. The unleashing of pent up demand after more than a year of quarantining is exacerbating that YoY change to at least a small extent as it quickly catches up to and, in some instances, overtakes supply.

3. Low to moderate inflation is normal – A small amount of inflation is the sign of a healthy economy. Most economists believe that low, stable and foreseeable inflation is actually good for the economy. With predictable inflation expectations, businesses can set future prices with confidence and consumers can predict those prices with relative certainty. It tends to help boost economic activity since consumers have an incentive to make purchases sooner rather than later knowing prices may be higher in the future. If inflation ceases to exist, consumers learn to delay purchases, reducing aggregate demand, leading to less production, job losses and a faltering economy.

4. Short term hedges – Commodities exposure can be an effective short term hedge against inflation given the high, positive beta to the CPI index. Commodity prices tend to move higher with inflation and are therefore a great way to hedge against spiking inflation in your portfolio. Treasury Inflation-Protected Securities (TIPS), particularly shorter maturity TIPS, are another popular option as their prices are pegged to CPI. As CPI increases, so do the value of TIPS securities.

5. Long term perspective – Over longer periods, commodities, depending on how you access them, tend to have returns in line or slightly behind inflation. Given the fact that inflation is hard to predict/time, this can be a fairly persistent drag on performance to hedge something that happens a small fraction of the time. The best defense against making hasty, emotional decisions is to maintain focus on your time. Over longer time periods, most asset classes represented in diversified portfolios outpace inflation on the time horizon. If it’s more than 5 years and your portfolio is well diversified, you should be well positioned to outpace inflation.

6. Asset class most at risk – High quality bonds have been in a tremendous 40-year bull market driven by ever decreasing interest rates. With the iShares AGG ETF measuring in at 1.48% (May 18, 2021) in terms of yield to maturity YTM and average inflation of 2.6% since 1985 (which has been a fairly benign inflation period) high quality bonds are at serious risk of being a drag on real returns. While this asset class has been a staple in portfolios of all shapes and sizes, forward looking returns are muted. While there are still benefits to holding a high quality bond allocation in most portfolios, investors with large allocations to high quality bonds should work with their advisor on ways to mitigate this risk.

7. Worst case scenario – The 1970s are the best example of what a worst-case inflation scenario looks like. Both stocks and bonds generated negative real returns as both markets were unable to keep pace with the YoY increase in inflation, which averaged over 7%. While it was a decade that was tremendously difficult for many investors, there were many lessons learned. Central banks now understand that a commitment to price stability is essential and have therefore adopted specific target measures for inflation. By doing so, they have created enhanced transparency and reduced uncertainty which helps to calm markets.

Conclusion

Our most important job as an investment team is to build portfolios that maintain or enhance your purchasing power. That means matching or outpacing inflation over your specific time horizon.

The most effective tool in our toolbox is the ability to build multi-asset class portfolios, combining uncorrelated return streams that maximize return per unit of risk and help increase the consistency of those returns. Over time horizons of 5 years or more, this leads to high odds of success in outpacing inflation.

Ultimately, positioning portfolios for elevated inflation is really a question of time horizon. If you’re concerns are short term in nature, then exposure to commodity prices is the best hedge available. The tradeoff is that over longer time horizons, commodities perform poorly relative to other asset classes. Not to mention commodity’s materially higher tax rate on short term gains relative to long term gains.

If your time horizon is longer term, you are better off staying mindful of historical patterns and diversifying for multiple scenarios. Historical patterns indicate that most asset classes will produce returns in excess of inflation, especially when they work together within a diversified, multi-asset class portfolio. Keep in mind that inflation is unpredictable and sometimes short lived. Investors are urged to consider their long term goals so as to not stray too far from their asset allocation, introduce too much risk into their portfolios or end up highly concentrated in one particular asset class.