Positioning Portfolios for a Variety of Inflation Scenarios
The near-term outlook for inflation continues to suggest a temporary spike, reflecting an adjustment higher in price levels as the global economy recovers from the effects of the pandemic. Indeed, the most recent U.S. consumer price index (CPI) reading for April exceeded even the most bullish of forecasts, with a month on month increase of nearly 1% in the usually tame Core category.
Whether CPI will revert to trend after these base effects subside in the latter half of the year remains to be seen. Many forecasts along Wall Street, at the Federal Reserve, and in the White House expect it to do just that.
In April, the White House took the unusual step of releasing a blog postFootnote[1] attempting to calm the public’s apprehension over upcoming CPI prints. It expects inflation to climb over the next several months – due to transitory influences including base effects, supply-chain disruptions, and pent-up demand – before fading.
The Federal Reserve has repeatedly signaled it would look through any short-term rise, focusing instead on whether inflation can sustain above 2% -- as measured by personal consumption expenditures, or PCE, a gauge that tends to run slightly below CPI -- before officials tighten monetary policy. (For further insights into the Fed’s views on inflation, read our recent blog post, Realigning Inflation Expectations )
Though the short-term outlook is coming into view, there’s elevated uncertainty when it comes to longer-term inflation. And while we believe the balance of risks favors higher U.S. inflation for the next 10 years than was seen in the previous decade, the cost to protect against that rise – market-based inflation expectations – has only just reached policy targets. We think breakeven rates of inflation should come to reflect the Fed’s new paradigm as the recovery develops.
Possible drivers of higher inflation
In the U.S., President Joe Biden has unveiled massive spending plans, marking a rare confluence of accommodative fiscal and monetary policy, which has stoked inflationary concerns. Unlike previous shocks, economic weakness was not due to excessive indebtedness within the system. Rather, household, corporate, and financial sector balance sheets are much healthier than in prior post-recession periods.
Longer-term price pressures on commodities and supply chains remain, including companies potentially shifting more production to domestic sites. Furthermore, the Fed’s new policy framework is no longer preemptive, meaning officials want to let inflation run above target for some time, to compensate for undershooting for so long in the past.
After investors have experienced a prolonged era of benign inflation, portfolios may be underprepared for even relatively modest changes in both inflation and inflation expectations. It’s worth examining the state of different markets for the purpose of inflation hedging.
Global inflation-linked bonds
COVID-19 has been a global pandemic, with countries and regions experiencing economic downturn and recovery at different speeds.
In Europe, we expect GDP to normalize to pre-pandemic levels in 2022, with inflation remaining low and increasing gradually over the next 12 to 18 months. Looking further ahead, the five-year, five-year-forward implied breakeven rate shows markets expect average inflation between 2026 and 2031 will run about 60 basis points below the European Central Bank’s 2% target.
At current levels, inflation-linked bonds (ILBs) can provide a relatively inexpensive hedge against upside inflation risk, in our view. That sort of mitigation can be more difficult and expensive to source once signs of inflation reemerge.
U.S. Treasury Inflation-Protected Securities
Advances along the path to vaccinations and economic reopening may help the U.S. lead many other regions in the pace of recovery. With the Fed actively trying to stoke inflation, the five-year breakeven inflation rate is elevated. But the five-year inflation rate starting in five years’ time is only at 2.3%, right on top of the Fed’s target.
Treasury Inflation-Protected Securities (TIPS) differ from standard U.S. bonds in that the principal value is adjusted over the life of the note to compensate for changes in CPI. Still, much critical attention has been given to idiosyncrasies – such as reporting issues, internet capture, and hedonic adjustments -- within CPI measurements. We believe investors can often benefit from pairing TIPS with other assets that may offer more potent inflation hedges.
Commodities and currencies
Commodities, such as wheat, gold, and oil, tend to be highly correlated to inflation; when they rise in price, the costs of goods and services generally increase as well. As a result, investments in commodities can offer some of the highest levels of inflation hedging of any asset class, though they may also be subject to volatility.
Diversifying investments across currencies can also help hedge against inflationary forces in any one country or region. Over the long term, currencies of countries with higher inflation rates tend to depreciate relative to those with lower rates. Because inflation erodes the value of investment returns over time, investors may shift their money to markets with lower inflation rates.
All investing requires preparing for a wide range of possible scenarios. In many cases, the cost today to mitigate against inflation can be fairly low. Strategies that combine different real assets based on each one’s relative potency in hedging against inflation may be particularly effective.
For a deeper dive, see “A Framework for Sizing Real Assets to Manage Inflation Risks .”
Steve A. Rodosky is a managing director in the Newport Beach office and a portfolio manager for real return and U.S. long duration strategies. Lorenzo Pagani is a managing director and portfolio manager focused on European government bonds.