Inflation hurts investors in many ways, and thus planning for it is an important part of the investment process. Traditional bondholders, for example, suffer when inflation erodes the purchasing power of their fixed coupon payments. Similarly, stock investors lose, particularly over the short term to intermediate term, when their dividend payment and capital appreciation don’t keep pace with inflation, largely because the companies themselves have a difficult time raising prices fast enough to match the inflation-led increases in expenses. In the long run, companies can pass inflationary costs (e.g., labor and materials) on to their customers. But it can take years for this “pass through” to make its way through the economy.
After years of relatively benign inflation, investors are starting to worry about higher levels of inflation in the (near) future. For example, immense fiscal deficits, as far as the eye can see, have many believing that the United States will try to “reflate away” its substantial debt burden. This concern is priced into the Treasury markets now, with 10-year breakeven rates—that is, the yield difference between nominal Treasuries and TIPS—ramping up from essentially zero at the start of the year to 1.8% per annum at the end of May.
Many investors have most of their liquid assets in mainstream stocks and bonds. So, if inflation is about to rear its ugly head for the first time in a quarter century, most of us are badly exposed. Given their vulnerability to inflation, many investors are adding dedicated “real return” assets to their asset mix. This shift is in the early stages, with most investors concentrating on those asset classes with the most direct link to inflation such as TIPS and real estate. These allocations to real return assets are rarely done in a diversified way, and even more rarely on a scale large enough to matter. We find that a real return mandate works better if it embraces an opportunistic and tactical approach to the puzzle built on a broader toolkit of asset classes.
Real Return Choices
So, if inflation is a real threat, what choices does an investor have for generating real returns?
TIPS is the logical choice for real return allocations because of its structural link to rising prices. Other asset classes, such as real estate, commodities, infrastructure, and timberland are also attractive because of their lower correlation with stocks and bonds.
Another way to assess the attractiveness of an asset class is to look at its correlation with inflation. Table 1 illustrates the quarterly correlation to inflation of a wide roster of asset classes since the inception of the S&P Global Infrastructure Index in 2002.
As Table 1 shows, traditional stocks and bonds offer little protection from inflation over this time period—hence the reason for the expansion of real return programs across institutional and private portfolios. Most of the commonly accepted real return asset classes (highlighted in blue) provide significantly better inflation protection—as we would expect. Timberland is an odd outlier, but this may be due to the use of land appraisals in assessing the returns: when inflation accelerates, it may be reflected in the appraisals in future quarters, not the current quarter.
Interestingly, four asset classes not normally associated with real return—bank loans, high-yield, convertibles, and local currency emerging markets bonds—provide inflation protection which is comparable to, or better than, TIPS. Bank loans surprisingly offered an even higher correlation than commodities! All four of these “underrated inflation fighters” had a more direct link with rising prices than infrastructure and timberland.
These data invite the question: “Why not deploy a full roster of asset classes in a real return portfolio?” We find that a true inflation-hedging portfolio should have a broader toolkit than just conventional real return assets like TIPS, real estate, and commodities.
A Tactical Overlay
Many investors adhere rigidly to a long-term asset allocation rather than tactically moving among the asset classes. Such an approach tends to hurt investors in the tough times. Consider what happened in the worst inflationary period in the United States over the past 100 years. From January 1977 through April 1980, year-over-year inflation ramped up from 5% to over 14% in less than 3½ years. During that period, most asset classes failed to deliver returns in excess of inflation.
As Table 2 shows, commodities and REITs finished near the top of the list. Surprisingly, the best performing asset class—at 14% real—was U.S. small cap. International equities offered the best real return Sharpe ratio—not commodities and not REITs!1 As expected, long bonds were the worst performing asset classes, with long credit and long Treasury indexes producing real returns of approximately –11.5%. On a cumulative basis, this translates to a 40% loss of purchasing power. Isn’t this what real return mandates are supposed to protect against?
Perhaps even more noteworthy is the volatility of these assets over this inflation ramp-up period, which ensured opportunities for tactical shifts in these assets. As evidenced in Table 3, there were ample opportunities to capture significant real returns in the shorter time periods. For example, REITs earned real returns of +12% in 1977, –11% in 1978, +17% in 1979, and –7% in the first four months of 1980. We see similar variations in the other asset classes. A tactical exposure to a broader set of asset classes provides an opportunity to add value over the static exposure to the traditional asset classes over this time period.
Inflation is the largest single enemy to long-term investors. The goods and services we purchase in retirement will be priced in tomorrow’s dollars, not today’s. Rapid acceleration in inflation—reflation—dramatically impacts mainstream bonds and, to a lesser extent, stocks. Thus, investors are wise to include dedicated real return exposures in their portfolios. But the devil is in the details. Those that narrowly concentrate on static real asset exposures are fighting rising prices with one hand tied behind their back. To deliver the knockout, inflation fighters need a combination of an expanded toolkit and disciplined tactical exposure management.
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1. Part of this lies with foreign currency exposure. EAFE outperformed the local currency variant by 8% per annum above, indicating that exposure to foreign currencies is just as important in a real return portfolio. (Calculated as the difference between the EAFE Gross Total Return and the EAFE Local Currency Total Return based on data from Morningstar Encorr.)