By Robert Gahagan and William Martin
Sponsored Content – American Century Investments
Inflation has dominated conversation in the investment world recently, as analysts and market participants consider the potential timing and likelihood of various inflation scenarios. 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. But precisely because it is impossible to predict inflation outcomes, we suggest a modest, permanent allocation to inflation-hedging strategies such as inflation-protected bonds, commodities, non-dollar investments, and real estate-related securities.
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:
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Lack of wage pressure
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Excess industrial capacity
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Weakness of housing market in the U.S.
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The U.S. economy is less energy-and-commodity-intensive than in the past
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, 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:
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Monetary policy
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Fiscal policy
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Weak dollar
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Transformation of emerging market economies
Add it all up, and while it is impossible to predict how events will transpire, uncertainty around inflation and the likelihood of an inflation “surprise” are 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.
Planning for Uncertainty with Inflation-Hedging Assets
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. But 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 (or a “ready-made” portfolio that offers a combination of these investments in a single, off-the-shelf inflation-hedging portfolio) is a much more sound investment approach. Or, as a popular investing aphorism goes, it’s better to get the timing right ahead of time.
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. This makes TIPS attractive to investors looking to hedge against increases in CPI. 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 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. 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.
Gold
Unlike other commodities, gold enjoys a 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 investment trusts (REITs) 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. REITs have the additional benefit of rising rent payments in inflationary periods.
Non-Dollar Investments
Non-dollar investments, such as stocks issued by overseas companies, 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. Emerging market securities have particular inflation-hedging advantages because these shares can be an effective way for U.S. investors to guard against the inflation pressure resulting from emerging market 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.
Incorporating a Portfolio of Inflation-Hedging Assets
Our analysis indicates that combining these inflation-hedging assets in a single “inflation-fighting portfolio” may provide better risk-adjusted returns than an investment in any of these securities alone. These data match our intuitive belief that comprehensive inflation protection is the best solution for investor portfolios.
Scale Inflation Hedge to Match Risk
But how much inflation protection is enough? Some studies call for anywhere from 10% to 50% exposure to inflation-hedged assets, with lower exposures the further from retirement or other liability. 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.
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. For example, traditional 60/40 stock/bond portfolio incorporating a single, off-the-shelf inflation-hedging portfolio comprised of many individual inflation-hedging assets would now be allocated 54/36/10.
More Inflation Insight Available
This is an executive summary of a longer position paper on this topic by Robert Gahagan and William Martin, CFA. The full paper is available by contacting your American Century Investments wholesaler or by going to americancentury.com/ipro.
This information is not intended to serve as investment advice; it is for educational purposes only.
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. This information is not intended to serve as investment advice.
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