Inflation in the U.S. has accelerated fromnear zero in 2015 to 2.5% in 2018 (according to the Consumer Price Index orCPI), propelled by trade tensions, strong consumer spending, the tight labormarket, and a boost in growth from tax reform and other fiscal stimulus. Afterso many years of low inflation, the rise in 2018 points to the possibility ofaninflation surprise.
Such a surprise could be damaging because many investors may be too reliant ondiversification achieved by investing in a portfolio of stocks and bonds,which is predicated on the historical negative correlation between the twoasset classes. However, this diversification may not work as well goingforward because correlation between stocks and bonds tends to rise wheninflation is elevated. Therefore, we suggest investors consider real assets(inflation fighters) to make portfolio diversification more robust and hedgeagainst the risk of higher inflation.
Will stocks and bonds deliver the same diversification at higher inflationrates?
The correlation between U.S. stocks and bonds has been low or negative wheninflation has been low to moderate. Over the past couple of decades of lowinflation, portfolios that were diversified across nominal bonds and stockstherefore tended to fare well on a risk-adjusted basis. It is this positiveexperience that is shaping most investors’ approach to inflation today.
However, this might not be the best way to address inflation risk goingforward: Stock-bond correlations tend to increase when inflation is eitherhigh or rising, as shown in Figure 1. This could be a big problem forinvestors worried about inflation because positive correlations essentiallymean less effective portfolio diversification.
We believe inflation in the near future will be higher than in the recentpast. U.S. CPI inflation has been above 2% for 12 consecutive months, and corepersonal consumption expenditures (PCE) is at the threshold of the FederalReserve’s target of 2%. Since inflation is a lagging economic indicator,one may reasonably expect inflation to remain elevated in the next fewquarters, reflecting the current acceleration in U.S. economic growth.PIMCO’s latestCyclical Outlook forecasts U.S. inflation in the 1.5%–2.0% range in 2019. Furthermore, the possibility forinflation surprises has increased as the Federal Reserve, along with othermajor central banks, appears more comfortable with inflation running at orabove the target, meaning that central banks are less likely to hit the brakeson growth even if inflation overshoots for some time.
Protecting portfolios from higher inflation and uncertain stock-bondcorrelations
PIMCO’s midyear asset allocation outlook, “Late-Cycle Investing,” notes that inflation is one of the four key investment themes atthis stage of the business cycle.Yet, most investment portfolios may not be protected against inflationsurprises(defined as the difference between realized inflation and inflationexpectations from a year ago).
As Figure 2 shows, stocks, bonds and the traditional 60/40 stock/bondportfolio all have negative inflation betas such that when inflation surprisesby 1%, the traditional 60/40 portfolio would lose 1.1%. Over the last severalyears, inflation has been surprising on the downside, and equities have beenpositively correlated with inflation surprises. Figure 2 shows how this recenttrend hasn’t been the case over the long term. It is noteworthy thatinflation surprises are not rare; in fact, we estimate that the probabilityfor an upside inflation surprise today significantly exceeds the probabilityfor a downside surprise, given recent new tariffs, continued trade tensions,late-cycle fiscal stimulus and robust consumer spending.
In today’s environment of elevated inflation, with risks skewed to theupside, we think investors should consider an allocation to the real assetsshown on the right side of Figure 2: TIPS (U.S. Treasury Inflation-ProtectedSecurities) or other sovereign inflation-linked bonds (ILBs), commodities,REITs (real estate investment trusts) and multi-real asset portfolios thathave the potential to perform better during times of rising inflation. Figure3 and the following sections delve further into these four potentialinflation-hedging solutions.
TIPS/Inflation-linked bonds (ILBs)
These fixed income assets are generally expected to perform well when growthslows, and they are the only assets where inflation protection iscontractually guaranteed: Their principal rises in line with inflation. Wethink two TIPS/ILB solutions merit special attention:
- Levered TIPS/ILBs: One drawback of TIPS/ILBs, typical ofthe highest-quality or “safe-haven” assets, is that returns aretypically moderate. However, they are attractive assets to lever (due to lowfinancing costs and collateral haircuts, on par with U.S. Treasury bonds); alevered approach can magnify return potential, while increasing inflationhedging. Further, an allocation to levered shorter-duration TIPS has thepotential to achieve these with only modest volatility or increased risk.Note that investing in the front end of the TIPS yield curve does not reducethe inflation-hedging because that comes from any adjustments in theprincipal, no matter the maturity; the inflation-hedging properties of five-and 10-year TIPS are the same.
- TIPS/ILB overlays: An overlay of TIPS, ILBs or CPI swaps(instruments that transfer inflation risk from one party to another throughan exchange of cash flows) can boost inflation protection, and usingexisting high quality, liquid portfolio assets as collateral means that onlylimited new cash/assets are required to fund the strategy. We find this tobe a capital-efficient way to hedge inflation risk without having to choosebetween return potential and inflation protection.
Commodities typically perform well in the late stages of an economicexpansion. They are highly sensitive to changes in inflation, and in somecases, they are the source of inflation surprises. For example, food andenergy prices represent 23% of the headline U.S. CPI basket but drive 88% ofCPI volatility (as of 30 June 2018). Not surprisingly, commodities have aninflation beta of more than five. Additionally, we believe that commoditieswill perform well in the near term as the sector has historically peaked onlyafter an expansion ends.
Sizing of commodity exposure is important since the asset class typically hashigh volatility. There are many types of commodities strategies; we seek thosethat deliver highroll yield and continuously evolve to provide the potential for diversified sources ofrisk premia (alpha) and better beta. Similar to TIPS, commodities are anexcellent asset class to consider for overlays and increased capitalefficiency.
Real estate investment trusts derive the majority of their revenues fromrental income and distribute 90% of their taxable net income as dividends(according to the IRS). Over the short term, REIT prices are correlated toequities and have low inflation beta. Over the long term, however, REITs canbe an effective liquid proxy for physical real estate and tend to trackinflation more closely; real estate rents and values tend to increase withinflation, which eventually passes through to REIT dividends and valuations.Furthermore, REITs have a low correlation to TIPS and to commodities (0.24 toboth, as measured by correlation of monthly index returns for REITs, TIPS andcommodities 1 from March 1997 to June2018), making them a potentially attractive addition to a balanced portfolioof real assets.
Multi-real asset solutions
A thoughtfully diversified mix of real assets can be a“one-stop-shop” solution for investors seeking a dynamic,responsive inflation-hedging allocation. The potential benefits of thisapproach are reduced volatility, higher return potential and meaningfulpositive inflation beta if the allocations perform as expected.
By investing in a mix of TIPS/ILBs, commodities, REITs, currencies and gold,investors can potentially increase diversification and benefit from multiplesources of alpha, derived by actively managing within eachinflation-fighting asset class and making tactical moves across assetclasses.
Key takeaways: seek to reduce inflation risk without sacrificing returnpotential
Milton Friedman once said, “Inflation is the one form of taxation thatcan be imposed without legislation.”
We at PIMCO spend countless hours studying and forecasting inflation anddesigning solutions that aim to protect investment returns from inflation“taxation.” We view inflation not only as a challenge, but also asan opportunity to generate strong absolute returns and alpha.
If inflation surprises to the upside in the years ahead, stock-bondcorrelations may increase, which would likely upset the inflation hedge thattoday’s dominant portfolio construction frameworks have derived fromdiversification in recent years. Drawing on the breadth and depth ofPIMCO’s investment expertise, we have pinpointed four forward-lookinginflation solutions that invest in real assets. Investing in single real assetclasses, such as TIPS, commodities and REITS, or a multi-real asset solution,could provide a measure of protection for investors by hedging againstinflation surprises, while also enhancing diversification and boosting returnpotential.
Please visit ourinflation pagefor more of PIMCO’s views on the complex drivers of inflationglobally.
CLICK HERE1 REITs represented by DJ U.S. Select REIT Index; TIPS represented by Bloomberg Barclays U.S. TIPS Index; commodities represented by Bloomberg Commodity TR Index. Source: PIMCO, Bloomberg.