ACTIONABLE ADVICE FOR FINANCIAL ADVISORS: Newsletters and Commentaries Focused on Investment Strategy

Inflation Update

May 14th, 2013

by Team

of North Peak Asset Management

For Professional Use Only

Basing investment decisions on inaccurate measurements of the inflation rate can result in investors unknowingly positioning their portfolios to lose purchasing power over time.This mis-measurement could be especially dangerous when yields are low.For example, evaluating a nominal 3% investment opportunity using an inaccurate 2% inflation rateindicates a marginally attractive 1% real return opportunity.However, if inflation is actually running at 5%, this becomes a deeply unattractive negative 2% real return investment.

While there are numerous valid ways to calculate the inflation rate, consistency in the methodology used is important to ensure biases aren’t unconsciously introduced.One of the most commonly used measurements of inflation, the Consumer Price Index (CPI), has been modified several times since its introduction, and an argument can be made that these changes mainly resulted in understating the inflation rate.

For example, in 1983 the Bureau of Labor Statistics (BLS) changed from using actualhouse sales to using a “rental equivalency” calculation.This is calculated by estimating owner-occupants’ housing costs asthe amount they forgo by not renting out theirhomes.Additionally, the BLS has introduced a “hedonic adjustment” which qualitatively adjusts forimprovements in goods.For example, a new$700 laptopis much more powerful than a$700 laptopbuilt 5 years ago.Therefore a qualitative hedonic adjustmentmight be made to reflect this by adjusting down the price of the new laptop by 10%.However, whethera consumer actually receives a 10% benefit from these improvements is debatable.Both these changes tend to put downward pressure on the CPI calculation.

IMPLICATIONS FOR PORTFOLIO MANAGEMENT

There are several organizations that create alternate ways of calculating inflation and one of them, Shadow Government Statistics, simply uses the BLS’s pre-1983 methodology (shown above as the gold area of the chart) to track inflation.Interestingly, it indicates a much higher rate of inflation than does the BLS’s current methodology(in green and red).

How should this analysis be incorporated into portfolios?One way is to make sure that the inflationhedging allocation of a portfolio isn’t tied exclusively to a measure of inflation thatmay understate inflation.

Many investors, for example,use Treasury Inflation Protected Securities (TIPS) as their primaryinflation hedge.However, because the inflation adjustments made to TIPS rely on the CPI, TIPS may not reflect the actual rate of inflation experienced by investors.

This makes the case for expanding the types of investments used to hedge inflation beyond just TIPS.Asset classes such as Global Natural Resource equities and Commodities, for example have the potential benefit of havingstrong correlations to changes in inflation while not being tied to the BLS's CPIcalculation. Further, these asset classes more directly reflect the actual increases (and decreases) of inflation because they are closely connected with the underlying fundamentals of inflation.Combining them with TIPS also has the possible benefit of creating a more diversified portfolio for hedging inflation risk.

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