Preparing Portfolios for Inflation
PIMCO
By Ronit Walny, Kevin Winters
August 15, 2012
- Although disinflation has seemed the more likely scenario in recent years, PIMCO expects inflation to accelerate from recent levels over the next three to five years, but double-digit rates are unlikely.
- An understanding of the constituents of the Consumer Price Index can help us design portfolios that seek to better defend against inflation. The core building blocks of such portfolios are commodities, Real Estate Investment Trusts and Treasury Inflation-Protected Securities.
“By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens.“
John Maynard Keynes
Inflation is a fearsome and stealthy force. It can pick our pockets and pilfer our wealth. Yet investors aren’t helpless. By understanding the sources and risks of inflation, we can design portfolios that seek to better guard against it.Â
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In recent years, disinflation has seemed the more likely scenario. Yet we see inflationary risks looming over the secular horizon.Â
Higher inflation risk
The heavy debt loads of developed countries may be the greatest potential source of inflation. The U.S. and other deeply indebted countries will be challenged to grow their way out, leaving inflation as one of the few remaining “solutions.â€Â
Emerging economies present another likely source. Historically, the low-cost goods and services these nations exported have been a disinflationary force. Yet as emerging markets become a growing share of global GDP, and their middle classes grow, they will increasingly demand, and likely push up prices for, food, energy and other globally traded goods.
A weaker U.S. dollar presents another potential danger. A lower dollar value would make U.S. goods and services more affordable globally. In an economic slowdown, this would be an enticing route to increase competitiveness. Yet it would raise the prices we pay for imported goods and services. Â
Capacity constraints are another potential spark. Owing to concerns over global growth, companies have limited investment in plant, equipment, and worker training. Yet to maintain existing capacity, continued investment is needed. When orders pick up, costly new investments will be needed to meet demand.
Given these scenarios, PIMCO expects inflation over the next three to five years to accelerate from recent levels, although double-digit rates are unlikely.
Given these scenarios, PIMCO expects inflation over the next three to five years to accelerate from recent levels, although double-digit rates are unlikely.
Consumer prices and inflation
In the U.S., the official barometer of inflation is the Consumer Price Index (CPI). Compiled by the Bureau of Labor Statistics (BLS), the CPI is a statistical estimate of the average change in prices paid by urban consumers for a market basket of goods and services. Figure 1 shows its major components:Â
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An understanding of the constituents of CPI can help us design portfolios to better defend against inflation. Food and energy have the most direct impact in the inflation basket. Even though their combined weights are about a quarter of the overall index, food and energy often drive the greatest month-to-month changes because their price movements tend to be more volatile, and are passed through more directly to consumers.
Shelter is the largest segment of CPI, yet components of shelter such as rent tend to be relatively stable over time. Due to shelter’s large representation in the CPI, though, slight price movements can drive significant changes in inflation.
Other important categories include education and medical care. These segments often are influenced by supply-side factors such as wages and technological improvements and demand-side dynamics including demographic and policy developments.
Other important categories include education and medical care. These segments often are influenced by supply-side factors such as wages and technological improvements and demand-side dynamics including demographic and policy developments.
The sources of inflation are more multifaceted than meets the eye. The price of apples, for instance, jumped 9% in the year ended June 2012. This change was influenced by multiple inputs, including energy, orchard labor, packaging, transportation and shelf space at the grocery store. These inputs, in turn, can be influenced by weather that impacts crops, geopolitical risks that influence energy prices and rent paid by grocery stores. In the broad scheme of the CPI, however, apples matter little: they make up less than one-tenth of one percent of the index.Â
Building blocks of inflation-focused portfolios
What do these complex interrelationships tell us about building portfolios to better preserve purchasing power?Â
First, we believe commodities, including food and energy (which are the most volatile components of the CPI), are essential; they can offer a direct defense against an increase in inflation. Additionally, Real Estate Investment Trusts (REITs), which pay dividends from income-producing properties, can offer a potential hedge against surprise increases in costs of renting a dwelling, which is a significant share of the shelter component of CPI.Â
For inflation risks such as wage increases, or rising education and medical expenses, we believe Treasury Inflation-Protected Securities (TIPS) cast the widest net because they are contractually linked to CPI and, therefore, all its components.Â
Non-dollar currencies can help offset the reduced purchasing power of a weaker dollar. Should other countries compete by devaluing their own currencies, precious metals such as gold can potentially act as a store of value relative to a basket of goods and services.
In theory, yields on investment products linked to short-term interest rates, such as Treasury bills, move in tandem with inflation; recently however, the Federal Reserve has kept short-term rates near zero to stimulate growth, making short-term instruments generally unresponsive to inflation.
Inflation, as Keynes said, can secretly confiscate an important part of one’s wealth. Although inflation has been subdued in recent years, PIMCO sees risks over the secular horizon. By understanding how various asset classes interact to affect consumer prices, investors can potentially design portfolios to better withstand inflation.Â
The best time to act is before the recognition of confiscation begins.
(c) PIMCO
