Planning for Inflation: The "Real" Deal
Point of View With Phil Green and Michael Fredericks
- Inflation is a fact of life for investors, and one that should be planned for.
- The effectiveness of individual "inflation fighters," such as TIPS, will vary based on the economic and inflation backdrop.
- A flexible, multi-asset solution can adapt to changing market conditions in an effort to protect against inflation and optimize returns.
Inflation hardly seems like the topic at the top of investors' worry list. Although it may not be the most pressing and immediate threat, it is a sure one. Unlike other types of investment risk that may come and go, inflation is a fact of life, quietly threatening to erode the value of your current savings and the future purchasing power of your portfolio. It is for that reason that Michael Fredericks and Phil Green believe it makes sense to have some element of inflation protection built into a portfolio, and ideally one with the flexibility to adapt to changing market conditions and inflation expectations.
- The everyday threat. Inflation is a fact of life for investors, and one that should be planned for. Consider that even relatively moderate inflation of 3% can result in the loss of more than half your purchasing power over 25 years.
- All inflation fighters are not the same. A number of different assets are commonly used to hedge against inflation, but all will not provide the same level of protection in every economic and inflation scenario.
- A multi-asset strategy is the "real" deal. A flexible, multiasset strategy that incorporates various inflation fighters and adapts to different market environments can be the best way to optimize after-inflation (i.e, real) returns.
What is the outlook for the economy and inflation?
Our expectation for the broad economy is for continued slow but positive growth. While the Fed has hinted at tapering its stimulative bond-buying program (otherwise known as quantitative easing or QE), it has been careful to telegraph to the markets its intention to keep interest rates low. This, in turn, should keep inflation relatively muted. With a full labor market recovery still elusive, we see little catalyst for the Fed to change its bent in the short term.
So, inflation expectations will likely remain low for the foreseeable future. That said, the unprecedented amounts of monetary stimulus injected into the economy over the past few years will most certainly have an impact on an investor's inflation-adjusted returns (also known as real returns) over the longer term.
We believe some component of inflation protection makes sense in virtually every portfolio.
Inflation is not an imminent threat. Why add inflation protection to my portfolio now?
It may not be the biggest threat today, tomorrow or next week, but inflation has to be a perpetual consideration for investors. Inflation cannot be combatted through a rear-view mirror; it has to be planned for before it picks up. We think investors should be building that insurance into their portfolios now, especially since the risks of rising inflation are greater today than they have been in recent years prior. We've had an extended period of QE and very accommodative policy on the part of central banks around the world. As these policies lead to an acceleration in growth, they will also beget inflation.
Investors should also consider that inflation data is not the first place they will see inflation. They will feel it first—in the rising costs of goods and services. The chart below illustrates the quandary well: earnings simply are not rising at the same rate as the cost of many modern-day essentials.
Which types of assets historically have offered the greatest cushion against inflation?
Over time, investors have used a variety of different securities in an effort to hedge against inflation risk. The most commonly used asset classes include Treasury Inflation Protected Securities (TIPS), gold, commodities, real estate and equities. Each of these investments historically has done well in different inflationary environments, but all have not necessarily exceled in every inflationary environment. Individual categories of investments will react to specific inflationary environments with different levels of performance volatility. Some will do better in a rising growth/rising inflation environment, while others might outperform in a slow growth/rising inflation environment.
We do not necessarily believe there is one "best" asset class to fight inflation. The correlations between inflation-sensitive asset classes and inflation are constantly changing, and as other market factors (e.g., economic growth, employment, political forces) change, the performance of these investments are often quite different. We believe the best defense against inflation—and the best way to preserve future purchasing power—is through a diverse mix of inflation-fighting assets.
Why not just increase my exposure to TIPS to achieve greater inflation protection?
TIPS may not be an effective inflation hedge in all environments, and in the current environment they are particularly vulnerable. TIPS are a form of Treasury security. Treasuries, as many investors know, have been on a three-decade run of falling yields and rising prices (Treasury yields and prices move in opposite directions). Investors have been rewarded with attractive capital appreciation, but that cycle is nearing an end. In fact, interest rates have already risen quite a bit this year, meaning Treasury prices have fallen. To the extent rates continue to trend upward, Treasury-related investments will continue to lose value. And those with relatively higher duration (a measure of interest rate sensitivity) will suffer more.
The TIPS index currently has a duration of roughly eight years and, therefore, could face significant downward price pressure when interest rates rise. In this scenario, rising rates can override the positive benefits of the inflation protection provided by TIPS. (See hypothetical case below.) So price weakness as rates rise is a risk for holders of TIPS. Meanwhile, prospective investors should consider that current yields on TIPS funds are still near all-time lows, making them relatively expensive to buy.
TIPS Could Lag if Rates Rise
Hypothetical Stress Test Using BlackRock Economic Scenario TesterTM (BEST)
|Inflation +2%||Interest rates +2%|
Source: BlackRock (Portfolio Risk Tool) as of 3/29/2013. Interest Rates +2% assumes the 10-Year Treasury rate rises 2%. Inflation +2% assumes the Consumer Price Index rises 2%. Materials stocks represented by the S&P Global 1200 Materials Sector Index; REITs by the FTSE EPRA/NAREIT Developed Index; commodities by the Dow Jones UBS Commodity Index; high yield bonds by the Barclays High Yield Index; TIPS by the Barclays US TIPS Index; cash by the Barclays 1-3 Month Treasury Bill Index; bonds by the Barclays US Aggregate Bond Index. It is not possible to invest directly in an index. Past performance does not guarantee or indicate future results. Projections or other information generated by the BEST tool are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results.
What then is the best strategy for incorporating inflation protection into a portfolio?
We believe protecting your assets against inflation requires a flexible, multi-asset solution that can quickly adapt to different market environments.
Consider the limitations of each individual "inflation fighter" in isolation: As just detailed, rising interest rates will be a drag on TIPS portfolios over the long term. Meanwhile, commodity-related strategies have at times shown high levels of volatility. They are often best used in conjunction with other inflation-sensitive assets rather than as a single strategy. The same could be said of REITs.
Ultimately, the effectiveness of single-asset-class inflation hedges can vary dramatically based on market conditions. They can introduce high volatility and their valuations can change significantly over time. A diversified, tactically managed, multi-asset portfolio seeks to exploit the best of each by understanding the drivers of a particular inflation scenario and allocating across those assets with the potential to outperform in that specific scenario (e.g., rising growth/falling inflation; rising growth/rising inflation; falling growth/falling inflation; falling growth/rising inflation). We believe this can result in better risk/return characteristics and improved inflation protection through various market cycles.
What are the benefits of diversifying away from more traditional assets?
Traditional equity and bond investments tend to underperform in periods of rising inflation. Rising inflation often coincides with rising interest rates, a negative for traditional bonds, as well as a drop in company earnings, a negative for traditional equity securities. Throughout history, in the years in which inflation has spiked dramatically, traditional stocks and bonds have tended to suffer negative returns. (See table below.) We believe a portfolio composed of diverse, tactically managed inflation-sensitive assets with attractive long-term risk/return characteristics offers a relative advantage during these tricky periods of rising inflation. While diversification does not assure profits or prevent loss, the strength of one asset can help offset weakness in another, and vice versa.
Traditional Assets Are Not Enough When Inflation Spikes
Real (After-Inflation) Returns During Five Worst Inflation Years
|Year||US Inflation||Stock Real Returns||Bond Real Returns||Cash Real Returns|
|Real Return = Total Return - Inflation|
Source: Morningstar. Past performance does not guarantee future results. Index performance is shown for illustrative purposes only. It is not possible to invest directly in an index. Stocks are represented by the S&P 500 Index; bonds by the Barclays Capital US Aggregate Bond Index; cash by the BofA ML 3-Month T-Bill Index; and inflation by CPI.
Inflation is a big concern for retirees. Is this strategy appropriate for them? Shouldn't they be growing more conservative?
The answer is "yes" on both counts. Investors who are at or near retirement are likely transitioning their portfolios to be more conservative. They need to live off the nest egg they've accumulated over the years, and that means protecting it against a significant negative event. The problem is that the assets historically used to reduce risk in portfolios (i.e., Treasuries and other core fixed income) tend to be among the worst-performing assets in periods of rising inflation. And in the scenario of rising rates and falling prices we just described, Treasury-heavy portfolios are at a real danger of losing value—offering no cushion against inflation. We believe a professionally managed, multi-asset approach to inflation protection is a much better option.
At BlackRock, our multi-asset inflation strategy, like all of our portfolios, is backed by disciplined risk management processes that include daily risk reviews and stress tests. It's another layer of due diligence and protection for our investors. We have portfolio construction discussions on a weekly basis and conduct senior management reviews of performance and risk levels monthly. This comprehensive approach means that investment decisions in all our client portfolios are made with an eye toward understanding how each decision might impact the portfolio's overall risk profile. While risk cannot be avoided, it can be managed. We believe this is very important for all investors, but perhaps especially for retirees who are now in the decumulation phase of their financial life.
Let's assume inflation stays very low or even declines. Does my allocation to inflation fighters then become a detriment (opportunity cost) in my overall portfolio?
This is a critical question for any investor looking to manage against inflation. The short answer is it depends on what you are using to fight inflation. A more traditional inflation portfolio composed primarily of TIPS, for example, may become a detriment if interest rates rise in the future. TIPS' extreme sensitivity to movements in interest rates is likely to produce negative returns as rates increase. A diversified inflation strategy has the latitude and flexibility to seek out sources of value in a wide variety of investment climates, including low-inflation scenarios. So while seeking to protect, it is also seeking to achieve some measure of growth.
Inflation is sort of the great equalizer in that it is a reality for every investor. For that reason, we believe some component of inflation protection makes sense in virtually every portfolio. A multi-asset strategy, in our view, is the best way to incorporate inflation insurance and long-term growth potential.
Any final thoughts/advice for investors?
We would reiterate the importance of flexibility. Evolving market conditions and changing inflation expectations can often cause inflation-sensitive sectors of the market to reprice quickly and exhibit very different risk characteristics in different environments. In this rapidly changing environment, flexibility in managing client portfolios is critically important. If you are seeking to construct a portfolio with the wherewithal to protect against the erosive effects of inflation, we urge you to consider incorporating an unconstrained, diversified strategy and to consider the merits of a quality portfolio manager with robust risk management analytics and a flexible mandate.
About the Author
Managing Director, Head of US Retail Asset Allocation for BMACS Group
Managing Director, co-head of the Global Multi-Asset Strategies Team
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