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Introduction
Inflation has dominated conversation in the investment world recently as analysts and market participants consider the impact of the financial crisis in 2008, the ramifications of both the monetary and fiscal policy response, and the potential timing and likelihood of various inflation scenarios. Indeed, in this new environment of heightened uncertainty and inflation risk, we are seeing a much greater dispersion in predicted inflation outcomes than we have in many years. Some are calling for rapidly rising inflation while others believe inflation will remain relatively contained. In fact, as recent as late fall 2010, the Federal Reserve itself mentioned the possibility of a double-dip recession and the threat of deflation.
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In this paper, we examine the competing forces at work that will affect inflation for the months and years to come. On the one hand, a whole host of factors are currently constraining inflation as experienced by U.S. consumers. On the other hand, U.S. monetary and fiscal policies and a number of pronounced global economic imbalances suggest an environment of high and rising inflation. The outcome of this debate is crucially important for financial assets, whose performance turns on the difference between expected and actual inflation—it is when inflation surprises to the upside that stocks and nominal bonds typically underperform and inflation-protected assets do best. But precisely because it is impossible to predict inflation surprises, we suggest a modest, permanent allocation to inflation-hedging strategies such as inflation-protected bonds, commodities, non-dollar investments, and real estate-related securities. As a result, we conclude the paper (beginning on page 10 with Part Three) by providing an analysis of inflation-hedging assets in different market environments, and suggesting strategies for protecting your portfolio from inflation risk.
Part One: Forces Currently Restraining Inflation
There are several crucial reasons why inflation in the U.S. is running at a slower pace than many pundits and market participants would seem to expect. First, weakness in the labor market means a lack of wage pressures, while the manufacturing sector is running well below capacity. A second, key consideration is the weakened state of the housing market, which plays such a vital role in the economy as a whole and represents a large part of inflation measures such as the government’s consumer price index, or CPI. Third, the economy is far less energy- and commodity-intensive now than at any point in the past, meaning we are less susceptible to the effects of commodity price shocks.
1. Lack of Wage Pressure and Excess Capacity
Inflation is often linked with rising wages—inflation can be exacerbated by workers demanding higher and higher wages to compensate for rising prices in the economy. That can result in a vicious cycle of ever-higher wages and inflation. This is important because wages and other compensation are typically among the biggest, if not the biggest, cost components that businesses face. But high unemployment and stagnant wages in the U.S. offset this effect—when the labor market is soft and wage and benefits pressures stay relatively low, it reduces the need for businesses to pass along those costs to consumers in the form of price increases.
In addition, companies have been able to offset higher non-labor costs with increasing worker productivity. Indeed, the latest readings on worker productivity show gains of nearly 4% year over year in 2010, according to the Bureau of Labor Statistics (BLS). That measure stands at almost 7% when applied to the manufacturing sector specifically. As long as the economy remains relatively weak, unemployment is high, and companies can squeeze greater output from existing workers, it is difficult to foresee an increase in wage pressures.
An insightful way to look at this problem is through the relationship of unit labor costs to CPI over time. Figure 1 illustrates the extent to which CPI has tracked labor costs lower, and shows that year-over-year changes in unit labor costs remained negative through the end of 2010. As long as year-over-year unit labor costs are negative, efficiency gains will continue to exert downward pressure on CPI.
Another important factor to consider is the changing nature of the labor force itself. First, the globalization of the economy and workforce has had a depressing effect on U.S. wages. It is probably not a coincidence that inflation in the developed world peaked in the 1970s and early ‘80s and has been declining more or less ever since. This coincides with China’s late 1970s decision to allow foreign investment and begin to take steps to participate fully in the global economy. Since that time, China has effectively been exporting deflation to the developed world through its lower wages and production costs. The comparatively low inflation environment of the last 30 years bears the undeniable stamp “Made in China.”
Second, the U.S. workforce itself has undergone a significant transformation over time, reducing the overall rigidity of wages in the economy. According to the BLS, union membership as a percentage of the working populace has declined markedly over time. Union members accounted for greater than 20% of the workforce in the early 1980s, when the Bureau began tracking the statistic. Today that number is less than 12%. The decrease in union membership means a smaller percentage of the workforce may be mobilized to argue for large, coordinated wage increases, and fewer workers carry comparatively high, rigid wage structures tied directly to cost-of-living adjustments relating to inflation.
Finally, just as excess labor capacity has a dampening effect on inflation, so too does excess manufacturing capacity. Recent measures of manufacturing activity indicate roughly one-quarter of U.S. industrial capacity is untapped. Said differently, for any increase in demand for U.S. manufactured goods, there is a ready supply of factory output prepared to come on line and offset any potential inflationary pressure.
2. Weakness of Housing Market in the U.S.
Housing deserves special comment in any discussion of U.S. inflation. In terms of inflation measures, housing is far and away the largest component of CPI, making up 43% of the index when combining both primary and owners’ equivalent rent (CPI measures housing costs not in terms of changes in home prices, but by estimating the rental cost of a given property). Declining costs for shelter go a long way toward explaining the slowdown in CPI in recent years (see Figure 2).
What’s more, the housing downturn has implications for the broader economy. First, home equity accounts for about one-fifth of consumer net worth, and housing-related wealth effects have often been cited as important spurs to consumer spending. Second, home sales, construction, and renovation drive demand and pricing trends in a number of industries and categories, from construction and wood products to mortgage finance and real estate brokerage fees. Third, some analysts estimate that fully one million American jobs were a direct product of the housing bubble and have been permanently eliminated. That is a significant army of the unemployed and underemployed whose effect is to create downward pressure on wages across many sectors of the economy. Similar aftereffects of the housing bubble are being felt across virtually all developed economies, and are crucial to the argument for relatively contained inflation for the foreseeable future.
However, we should mention a peculiar quirk in how CPI accounts for housing costs. Rents exerted a downward pressure on CPI in 2010, when the first-time homebuyers tax credit encouraged many renters to leave the market in favor of homeownership. But since the expiration of the tax credit, rents have begun rising again. Other things being equal, this will nudge headline CPI higher in 2011, despite the large overall dampening effect we believe housing has had on inflation as a whole.
3. The U.S. Economy Is Less Energy- and Commodity-Intensive than in the Past
This is not your father’s stagflationary economy of the 1970s—the radical transformation of the U.S. economy in the last 40 years in terms of its production base, energy consumption, and conservation efforts means even $100-per-barrel oil does not translate directly into the spiraling inflation of the 1970s. Then, a more energy-intensive economy with a greater percentage of output from the industrial sector was subject to severe setbacks from the surge in oil prices. The post-industrial, more service-oriented nature of the modern U.S. economy means commodity price shocks in general and oil price shocks in particular are not as big a concern as they were in the 1970s. According to the U.S. Energy Information Administration, the energy intensity of the U.S. economy (measured by energy use per dollar of GDP) has declined an average of 2% per year since 1992. This is due in large part to the evolution of the economy away from more energy- and commodity-intensive manufacturing activities toward a service-based economy over time.
Part Two: Inflationary Forces at Work
The extraordinary U.S. monetary and fiscal policies enacted in the wake of the 2008 Great Recession suggest higher inflation ahead. Indeed, the monetary policy decisions of the Federal Reserve (the Fed), ostensibly intended to stimulate U.S. growth, have sweeping global ramifications. The use of the dollar as a reserve asset, the greenback’s role in commodity pricing, and the linkage of many emerging market currencies to the dollar all mean it is not sufficient to look at events in the U.S. alone. With that in mind, it is crucial to recognize the changing role of emerging market economies with respect to inflation. In effect, they have evolved from a powerful global deflationary force into a driver of commodity price inflation, as we discuss in greater detail below. We see four major forces at work that may lead to higher inflation ahead:
- Monetary policy: The fed funds rate is at record low levels; the Federal Reserve is using a whole host of novel policy tools; and assets on the Fed balance sheet are greater than they have ever been.
- Fiscal policy: Deficits in the United States and across the developed world are higher than ever as a result of stimulus policies intended to lift the economy out of the Great Recession. Burgeoning entitlement spending and rising interest costs argue for massive structural deficits going forward.
- Weak dollar: The weaker the greenback, the higher the cost of imported goods, other things equal. In addition, commodities are priced in dollars, so not only do they become more expensive for U.S. purchasers, but dollar-priced commodities become cheaper for buyers holding non-dollar currencies, encouraging demand.
- Transformation of emerging market economies: Emerging economies have effectively exported deflation to the developed world for the last 30 years or so. This is beginning to change, however, as emerging markets have seen a meaningful increase in their wages, share of the global economy, and commodity intensity of their economic output.
Now let us explore each of these topics in more detail, beginning with some crucial lessons to be learned from prior Fed policy decisions, which we believe provide further insight into the future direction of monetary policy and inflation.
1. Stimulative Monetary Policy Reflects Dual Mandate
A brief review of past Fed policy decisions and statements in the Greenspan/Bernanke era suggests there is remarkable tension in the Fed’s dual mandate to maintain both price stability and full employment. (Contrast this with the European Central Bank, whose sole directive is to maintain price stability without explicit concern for resulting economic and employment conditions.) While the Fed has struggled with these competing marching orders in the past, we believe this balancing act is proving particularly difficult to negotiate this time around. First, let’s look back to the bursting of the dot-com stock bubble in 2000 and ensuing recession of 2001, when the Fed cut rates dramatically, but was slow to raise interest rates following the recovery. The reason often cited for the Fed’s reluctance to raise rates was the so-called “jobless recovery” of 2002–03, when unemployment came down more slowly than during past recoveries. At the same time, slack in the labor market and manufacturing sectors meant the rate of inflation was low and falling in this period. These conditions left the door open for the Fed to keep interest rates low for an extended period, and then raise them only gradually beginning in mid-2004, even though the recession was officially deemed to have ended in November 2001. Broadly speaking, the current economic conditions of modest growth, slack labor markets, and low inflation are similar to those experienced coming out of the 2001 recession. We see this as a likely template for the current round of easing—the Fed will be slow to remove stimulus if U.S. unemployment remains stubbornly high.
It is certainly instructive that in the very speech making the case for the enactment of a second round of quantitative easing (QE2)—at a conference organized by the Federal Reserve Bank of Boston in October 2010—Bernanke spoke extensively about the labor market. He expressly stated that he did not believe that demographic and structural changes were responsible for the slack in the job market, and instead put the high rate of joblessness down to the sharp contraction in economic activity in the wake of the financial crisis: “The Federal Reserve remains committed to pursuing policies that promote our dual objectives of maximum employment and price stability. In particular, the FOMC is prepared to provide additional accommodation if needed to support the economic recovery.” It should be clear that the Fed faces a profoundly difficult quandary that has, in past economic cycles, led them to err on the side of excessive stimulus.
These comments by Bernanke and many others we don’t have time to review here provide useful insights into the Fed Chairman’s decision to enact a series of unprecedented bank liquidity and asset purchase programs as remedies to the 2008 credit crisis, totaling in excess of $2 trillion (Figure 3). These policies were crucial to propping up the banking system, which faced serious challenges in terms of asset quality, capital adequacy, and liquidity. But much of this capital continues to sit on bank balance sheets in the form of excess reserves.
This unprecedented buildup in bank reserves (Figure 4) is a key potential source of U.S. inflation. So far, this transmission mechanism is switched off in the U.S.—the so-called “liquidity trap” of limited lending and borrowing no matter how low interest rates go. But should the flood gates open and banks begin to make loans again with that capital—as the economy and creditworthiness of U.S. consumers improve—these reserve assets would be central to growth in the money supply. This raises the specter of a textbook inflationary scenario where the money supply grows faster than the economy as a whole, resulting in too many dollars chasing too few goods.
2. Fiscal Policies Also Inflationary
Deficits in the United States and across the developed world are higher than ever as a result of stimulus policies intended to lift the global economy out of the Great Recession. This stimulus spending comes at a time when tax receipts plummeted following the decline in economic activity. The result is significant amounts of debt far out of line with recent historical standards. While there is some debate in academic circles about the link between debt and inflation when looking at the global economy over time, recent analysis shows that the United States has historically experienced high inflation in periods when public debt as a percentage of GDP exceeds 90% (see Growth in a Time of Debt, by Reinhart and Rogoff). As depicted in Figure 5, U.S. debt as a percentage of GDP is believed to have crossed the 90% threshold in 2010. It’s also worth pointing out that in an earlier work (see This Time is Different: Eight Centuries of Financial Folly) Reinhart and Rogoff found a strong historical precedent for inflation and currency depreciation being associated with financial crises.
A further looming challenge for the federal government comes from mandated cost-of-living adjustments to Social Security and other entitlement programs. Indeed, the first wave of the Baby Boom generation reaches full retirement age in 2012. Already in 2009, applications for Social Security hit a record high, perhaps as a result of unemployed workers being pushed into retirement. The inescapable point remains— massive entitlement spending leads to significantly higher projected debt levels going forward, pushing public debt well beyond thresholds historically associated with inflation in the U.S.
3. Weak Dollar’s Inflationary Effects
The Fed’s policies of record-low interest rates and unprecedented increases in the money supply argue for a weaker dollar. One effect of a weaker dollar relative to other currencies is that U.S. goods become cheaper for foreign buyers. And it is true that the decline in the value of the dollar has been a boon to U.S. exporters and helps explain the recent strength in the U.S. manufacturing sector.
But a weaker greenback also has the knock-on effect of forcing revaluations for the many emerging market currencies pegged to the dollar. What’s more, the majority of global trade takes place in dollars. For countries to maintain the competitiveness of their currencies with the falling dollar, foreign central banks issue money, selling their own currencies to purchase dollars. This is an important point: Foreign central banks actively printing and devaluing their own currencies in the name of maintaining trade competitiveness is in and of itself inflationary. Whether you are a central bank printing money with the intent to stimulate growth (the Fed) or to devalue your currency (Brazil, for example), the inflationary effect is ultimately the same. In effect, the falling dollar forces our trade partners to pursue inflationary policies of their own.
On this point, an interesting recent paper by Stanford economist Ronald McKinnon argues that periods featuring both easy U.S. monetary policy and a falling dollar have significant global inflation implications. He cites the cases of 1971 and 2003 to show that this combination of factors in the United States has translated into generalized worldwide inflation. He sees many of the same factors lining up again this time, arguing that the Fed is ignoring the early warning signs of emerging market inflation.
The falling dollar has other implications as well—the weaker the greenback, the higher the cost of imported goods, other things equal. The magnitude of this effect is clearly evident in Figure 6. In addition, a weaker currency translates into higher commodity prices—dollar-priced commodities such as gold, aluminum, and oil now all cost more in dollar terms for U.S. consumers. But the falling dollar relative to other currencies means commodities look cheaper to foreign buyers in 
non-dollar pegged currency, encouraging demand. The effect of these forces on commodity prices can be seen in the dramatic rise in the broad CRB commodity index since the peak in the dollar’s value early in the 2000s (Figure 7).
4. Emerging Markets Driving Commodity Scarcity and Inflation Fears
We have already seen how the falling dollar forces many emerging market economies to revalue their currencies, leading to inflation in their own economies. In this section, we are concerned with how the economic development of emerging market countries such as China and India have evolved over time from forces for deflation in the global economy to forces for inflation.
Some of the most telling statistics are those that relate to changes in the global labor force and wages over time. Earlier, we discussed the effect on U.S. inflation of cheap Chinese labor, depressing prices for a whole range of consumer products. But that effect looks set to reverse going forward, as wage pressures in China are growing rapidly (Figure 8). Now we’re seeing wage inflation in China grow at a double-digit annual rate year over year, which should translate into higher prices for everything from textiles to electronics.
Just as emerging countries may no longer be exporting deflation to the developed world through the medium of cheap labor, so too are they actively promoting inflation in commodity prices. This is a result of their economic growth over time and transformation from agriculture-based economies to manufacturing-, industrial-based economies responsible for a growing share of global output. According to OECD statistics, the world’s emerging economies represented 40% of global GDP in 1990. In 2010, that figure was 50%. By 2020, it is expected to reach 60%, given the difference in relative growth rates between developed and emerging economies.
What is significant about these figures is that even as the emerging market share of global growth is increasing, so too is the commodity intensity of that growth. “Commodity intensity” refers to the proportion of commodity use for each unit of economic output. Global commodity intensity is rising for the vast majority of major commodities—oil, gas, and coal in the energy space; corn, soybeans, and wheat among food commodities, etc.
Increasing commodity scarcity and tight inventories mean greater susceptibility to supply shocks, such as turmoil in the Middle East, droughts, flooding, etc. The combination of these factors suggests we may be at a tipping point in the global economy, wherein emerging economies no longer have a deflationary effect on the global economic system, but instead promote inflation as a result of rising demand for increasingly scarce resources.
Putting it All Together
It’s worth noting in concluding the contrasting arguments in Parts One and Two above that what we have seen in recent years is an economic reflation play by the Fed and other global central banks and governments. We believe those dramatic monetary and fiscal policy steps carry inflation risks. But those risks are being mitigated at present by a number of factors. Specifically, we saw in Part One of this paper that a whole host of factors are acting to restrain inflation as experienced by U.S. consumers. These factors include slack in the labor, housing, and manufacturing sectors, as well as the declining commodity-intensiveness of the U.S. economy. Meanwhile, in Part Two we concentrated on the four main areas driving concern about high inflation going forward. These were U.S. monetary policy, U.S. fiscal policy, the declining value of the dollar, and rapidly growing emerging market economies. While we can delineate the countervailing forces surrounding inflation, it is more difficult to forecast the likely result of their interaction. Add it all up, and while it is impossible to predict how events will transpire, we believe the risk of “tail events”—the probability of an extraordinary, unforeseen event (i.e., one at the “tail” of a normal distribution)—is greater than at any time in the recent past. In this environment of heightened uncertainty, we think it is vitally important to hedge investor portfolios against inflation risk with a modest, permanent allocation to inflation-protected assets.
Part Three: Protecting Against Uncertainty with Inflation-Hedging Assets
Everyone is keenly aware of the effects of inflation on purchasing power. What’s often overlooked, though, is the effect inflation has on a traditional portfolio. The double whammy of a loss in purchasing power coupled with underperformance in one’s investments can be particularly devastating. For example, one analyst estimates that for an investor in a typical balanced portfolio from 1972–82, the combined effect of purchasing power erosion and poor portfolio performance resulted in a 65% drop in real wealth given a 4% annual spending rate on initial portfolio value.
From an investor’s point of view, the big concern is unexpected inflation. Expected inflation is fairly straightforward to deal with. But the difference between expected and realized inflation is vitally important for asset performance—inflation surprises can dramatically affect the performance of inflation-sensitive assets. So, for example, lower-than-expected inflation is likely to be positive for the performance of stocks and nominal bonds, while higher-than-expected inflation readings can detract meaningfully from results. Indeed, while equities tend to outperform inflation in moderate inflationary scenarios, stocks tend to suffer from inflation surprises.
One market participant describes the importance of inflation surprises this way: “What matters most to the performance of various asset classes is not the level of future inflation, but rather the unexpected level of realized inflation. Simply stated, if the market price for goods and services reflects the average or consensus view for potential future inflation, only a deviation from the consensus will lead to value gained—or lost—by holding inflation-sensitive assets.”
Timing Inflation: Don’t Be Late to the Party
In contrast to traditional stock and bond investments, inflation hedges—such as inflation-protected bonds, commodities, non-dollar investments, or real estate-related securities—tend to do best precisely when inflation surprises to the upside. As we’ve discussed, record-high commodity prices and a number of pronounced global imbalances leave the economic system more susceptible to supply/demand shocks and other “tail events.”
In a moment, we will discuss a number of the investment tools available to hedge against large, unforeseen moves in inflation and the resulting portfolio impact. But here let us make a key point about timing—inflation protection, whatever the type, is most effective when purchased before inflation expectations are fully priced in to the asset in question. Because inflation surprises are by definition impossible to predict, “timing” the purchase of inflation-protected assets is unlikely to be successful. Therefore, we believe a permanent allocation to inflation-hedging strategies is a much more sound investment approach. A comparison with life insurance may be instructive: The longer you wait, the more expensive such insurance becomes. Similarly, waiting for evidence of inflation to show up in CPI and other prominent measures likely means that the price of inflation-protected assets will have skyrocketed.
Inflation-Protected Assets
There are many potential inflation-hedging strategies for U.S.-based investors seeking to protect against a decline in the purchasing power of the dollar. Here we consider several of the most common, liquid inflation hedges that may be used to complement a traditional portfolio of stocks and bonds. In addition to these individual inflation-hedging assets are “ready-made” portfolios that offer a combination of these investments in a single, off-the-shelf inflation-protected portfolio.
TIPS, or Treasury Inflation-Protected Securities
TIPS adjust their principal and coupon payments for changes in the CPI. Issued by the Treasury, these securities are backed by the government’s “full faith and credit pledge” and offer a guaranteed return above inflation if held to maturity. What’s more, TIPS’ principal value at maturity cannot be below par, even in the event of deflation; however, it’s worth pointing out that when held in mark-to-market portfolios (such as a mutual fund), TIPS’ principal value can be adjusted below par. This combination makes TIPS ideally suited for investors looking to hedge their exposure to U.S. inflation as measured by the CPI. Our analysis indicates that TIPS are the single inflation-hedging strategy to produce positive real returns (performance after allowing for inflation) regardless of the level and direction of inflation over the last 30 years. (The Treasury began issuing TIPS in 1997, so our analysis used a model of inflation-linked bond returns provided by a third-party source for the period prior to TIPS’ introduction.)
But we should also point out that because TIPS are bonds, their prices are nevertheless sensitive to changes in real interest rates over short periods. This means that TIPS sold prior to maturity or held in a mark-to-market portfolio, such as a pension or mutual fund, can experience temporary price declines in periods of rising real rates.
Commodities or Stocks of Commodity Producers
An investment in commodities or stocks of commodity producers can be an effective hedge against inflation driven by rising commodity prices. Commodity prices tend to increase in periods when
- Demand outstrips supply for typical, cyclical growth reasons, such as we have seen in recent years, when surging emerging market growth has put serious strain on commodity markets;
- We experience supply shocks, such as the oil embargo, or the current Middle East tension, for example. Droughts and floods are examples of supply shocks common to food commodity markets;
- The dollar is falling in value, making dollar-priced commodities more expensive for U.S. purchasers.
As a result, an investment in commodities can be a good way to hedge against declining purchasing power. This strategy can be particularly effective in periods when commodity prices are rising but we have yet to see a flow-through to traditional measures of inflation such as CPI and assets linked to CPI, such as TIPS.
Here we should say a word about gold specifically. Unlike other commodities, gold enjoys a unique status as an alternative currency. Because of this relationship, the supply-and-demand dynamics for gold differ from other commodities—in addition to industrial and consumer demand, gold benefits from “alternative currency demand” in its role as a reserve asset held by world central banks. This reflects gold’s long-standing status as a hedge against the declining value of paper money.
Gold’s unique properties make it not only a hedge against inflation specifically, but uncertainty generally. As a result, gold has low or negative correlation to other major asset classes. This means an investment in gold might be well suited as a portfolio diversifier in inflationary scenarios accompanied by political or economic uncertainty, or when the inflation outlook itself is highly uncertain.
Equity REITs
The rationale for holding real estate-related investments is similar to that for commodities and other hard assets—when the purchasing power of the dollar is falling, investors would prefer to hold tangible assets. Real estate has the additional benefit of rising rent payments in inflationary periods. Our analysis indicates that equity REITs tend to perform best as an inflation hedge in periods when inflation is rising at a steady (less than 5% annually) but not rapid clip (greater than 5% annually). This performance reflects the gradual pace at which rents may be adjusted higher over time as the underlying leases expire and are renewed at the new, higher rate.
It’s worth pointing out that equity REITs have a mixed performance history in high-and-rising inflation environments. The relatively limited occurrence of high-and-rising inflation in the last 30 years gives us few samples to examine REIT performance over time. In addition, the performance characteristics for REITs are further complicated by the decline in interest rates and long rally in real estate from the early 1980s to about the mid-2000s. Nevertheless, our belief is that REITs can continue to make sense as an inflation-hedging asset going forward, even in high-and-rising inflation regimes.
Non-Dollar Investments
Non-dollar investments can be particularly good hedges against the declining value of the greenback. When the dollar’s value falls, investments in other currencies are worth more when translated back into dollars.
Here we should point out the particular inflation-hedging advantages of local currency emerging market securities. In addition to providing currency diversification, investments tied to rapidly growing emerging economies can be an effective way for U.S. investors to guard against the inflation pressure resulting from that growth. Furthermore, many emerging economies are natural resources exporters, meaning resource-based emerging market stocks are positioned to directly benefit from rising raw materials prices. Our research indicates that emerging market equities have provided significant positive real returns during periods of rising inflation over the last 30 years.
Inflation-Hedging Assets Across the Inflation Cycle
Next, we take the performance characteristics of these key inflation-fighting assets and overlay them on a curve depicting the inflation cycle, as shown in Figure 9. This presentation reflects the real (after-inflation) returns of various financial assets under different inflation scenarios, which we present in Figure 10.
Figures 9 and 10 taken together provide the rationale for a “portfolio approach” to inflation-fighting assets—no single inflation-hedging asset outperforms in each distinct inflation environment. Rather, a mix of inflation-hedging investments may provide better risk-adjusted outcomes across inflation regimes. Further, since the source and timing of unexpected inflation is, by definition, unknown in advance, a diversified or “comprehensive” inflation solution is the best way to protect one’s portfolio over time. We explore this point further in Figures 11 and 12.
Historical Risk-and-Return Analysis Argues for Portfolio of Inflation-Hedging Assets
It is instructive to look at the risk-and-return profiles for these common inflation-fighting assets over the last 40 years or so (Figure 11), and in a period of sustained high inflation (Figure 12).
Generally speaking, you see TIPS on the lower end of the volatility spectrum, consistent with their role as a comparatively low-volatility, low-cost, higher-reliability inflation-fighting asset. As you move out the risk spectrum, the inflation sensitivity of the various assets grows, but so too does the volatility of returns. As a result, the reliability of each individual inflation hedge decreases. This makes intuitive sense—TIPS provide a modest, government-guaranteed return over CPI, while gold and commodities trade on a number of economic, market, and other factors that make their return streams much less predictable over time.
But an inflation-fighting portfolio that includes each of these assets in equal weights outperformed all but one of these inflation-hedging strategies on their own for the two periods, but with significantly less risk. These data match our intuitive belief that comprehensive inflation protection is the best solution for investor portfolios. Finally, we conclude by looking at how to incorporate inflation-hedging assets in a diversified portfolio.
Portfolio Construction: Scale Inflation Hedge to Match Risk
Whether you believe inflation will be contained or rise significantly, even modest levels of inflation erode purchasing power and asset performance over long time periods. Retirement presents a special case, however, because this is the point at which investors face the greatest risk—they must finance the greatest amount of time in retirement, but will no longer be making regular contributions to offset declines in performance or purchasing power. As a result, the closer to retirement, the greater the investment risk from inflation. For this reason, our analysis suggests investors should scale their inflation-protection to match their exposure to inflation risk.
Inflation: The Efficient Frontier
Some studies call for as little as 10% to as much as 50% exposure to inflation-hedged assets, with lower exposures the further from retirement or other liability. Regardless of the exact level, the key point remains—investors need a real-return allocation as part of their overall portfolio. The ultimate allocation decision is likely a complex function of several variables, including an investor’s objectives, risk tolerances, time horizon (time to retirement, for example), and, crucially, vulnerability under various inflation scenarios.
Figures 13 and 14 explicitly demonstrate the degree to which an allocation to inflation-fighting assets improves the risk/reward trade-off of a traditional 60/40 stock/bond portfolio. These charts display the risk and return characteristics of a nominal 60/40 balanced portfolio, a pure inflation-hedging portfolio, and various combinations of the two, across inflation regimes. In Figure 13, we focus directly on the environment of high-and-rising inflation experienced from the early 1970s through 1980.
Figure 14 covers the entire period from 1973 to present, which captures a range of diverse inflation regimes. Our findings suggest that incorporating inflation-hedging assets into a typical balanced portfolio provides better risk-adjusted performance. Indeed, inflation allocations ranging from 10% to 50% of an investor’s total portfolio show clear movement down the risk spectrum and up in terms of return in both time frames. However, while it is also true that inflation allocations beyond the 50% level have historically delivered more return for similar levels of risk, we would caution investors not to become overly concentrated in inflation-hedging assets as allocations beyond this point come at the considerable cost of overall portfolio diversification.
We suggest that the source of funds for the inflation-hedged allocation should be proportional to the asset allocation of the overall portfolio to maintain consistent risk tolerances and relationships (see Figure 15). For example, a 10% allocation to inflation-fighting strategies in a traditional 60/40 stock/bond portfolio might mean a 6% overall allocation to stocks of commodity producers or to REITs, along with a 4% overall allocation to inflation-linked bonds. In that case, the allocation would now look like this: 54+6/36+4. In the case of a single, off-the-shelf inflation-hedging portfolio combining many individual inflation-hedging assets, the allocation of a typical balanced portfolio would be 54/36/10.
In Closing
In this paper, we detailed the competing inflation forces currently extant in the global financial system, and presented alternative investment strategies for hedging investor portfolios against inflation. Part One took us through reasons why inflation has remained comparatively muted in the U.S. In Part Two, we took a broader, global look at the inflation implications of U.S. monetary and fiscal policies, as well as the potentially important inflationary role of the dollar and growing emerging market economies. While the interaction and outcome of these forces cannot be known with certainty, we can say with a high degree of conviction that inflation uncertainty and the potential for unwanted inflation surprises is as high as it has been in a generation. Finally, in Part Three, we looked at a broad spectrum of inflation-fighting assets for ways to hedge inflation risk. We found that the effectiveness of inflation-hedging assets varied with the prevailing inflation regime. But two things were abundantly clear. First, there were significant benefits to using a “portfolio approach” in combining inflation-hedging investments. This strategy delivered significantly better risk-adjusted performance over time than holding a position in any single inflation-protected asset. Second, timing the purchase of inflation-hedging assets is also important—investors reap the highest degree of inflation protection by building positions before the market sees the white’s of inflation’s eyes. Or, as a popular investing aphorism goes, it’s better to get the timing right ahead of time.
The opinions expressed are those of Robert Gahagan and William Martin, CFA, and are no guarantee of the future performance of any American Century Investments portfolio. Statements regarding specific holdings represent personal views and compensation has not been received in connection with such views. This information is not intended to serve as investment advice.
Generally, as interest rates rise, bond prices fall.
Gold stocks generally are considered speculative because of their high share price volatility, and the fund’s share price may be affected by this volatility. Gold investments may be used to hedge against inflation, currency devaluations and general stock market declines, but there is no guarantee that these historical inverse relationships will continue.
International investing involves special risks, such as political instability and currency fluctuations. Diversification does not assure a profit or protect against loss in a declining market.
American Century Investment Services, Inc., Distributor ©2011 American Century Proprietary Holdings, Inc. All rights reserved.
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