December, 2016
The recent election of Donald Trump has lead to headlines predicting that inflation rates will rise (see, for example “Inflation Expections Soar…” at CNBC.com, and a column called “Donald Trump’s Win Fuels Bets on Inflation” in the Wall Street Journal). At Plum Street Advisors, we wanted to take this opportunity to consider the historical inflationary context, consider the future inflation risk, and revisit the case for inflation-sensitive assets in a portfolio.
Recent Inflation History
Inflation is a word that strikes fear into the hearts of any investor that lived through the 1970s in the US. By the end of the decade, inflation had reached an annual rate of almost 14%. The average price of a gallon of gasoline went from $0.39 in 1973 to $1.31 in 1981. The stock market, meanwhile, fell over 64% on an inflation-adjusted basis from a high in November 1968 through the low in July 1982. Neither stocks nor bonds offered much protection during the last inflation crisis.
Figure 1: Inflation since 1970
Source: Federal Reserve
Recent inflation levels have been at historic lows, as can be seen in the chart above, and current expectations for near term inflation are significantly less extreme than the levels seen in the 1970s. However, the impact of even small increases in inflation and on nominal interest rates can be greater than many people expect. Markets have reacted very quickly to higher inflation expectations under a Trump administration. The 10-year Treasury bond has already jumped a full percent from a recent low of 1.37% in July to 2.37% in late November. Consider that another 2.5% increase in the nominal rate of the 10-year Treasury from this point would lead to a 20% drop in its price, and you can see that even seemingly modest increases can have considerable portfolio effects.
The Risk of Inflation
The latest CPI figures put headline inflation at only 1.6% (as of October, year over year). That compares to a typical target inflation level of approximately 2%. Wage inflation was also still modest in the most recent release, with wages and benefits rising 2.3% over the year through September 2016 for civilian workers, compared to a 1.9% increase a year ago. But that’s not to say that there are no risks on the horizon.
There are several different types of inflation. The first traditional kind to consider is called “cost-push inflation”. This inflation will come about if the cost of wages or inputs rise. The second type of inflation is “demand-pull” inflation. This generally occurs if an economy is overheating and there is significantly more demand for goods than supply. Finally, there is a monetary explanation of inflation and this suggests that an expanding money supply could cause inflation. Clearly, the money supply has massively expanded over the past few years as the Federal Reserve has tried to pump money into the system to stimulate the economy (see Figure 2: Increasing Money Supply).
Figure 2: Increasing Money Supply
Source: Federal Reserve, Department of Commerce
The general explanation for why we have not seen inflation from the increased money supply is that the “velocity” of money – how quickly it moves through the system – has fallen sharply at the same time. Suffice it to say that all this extra money in the system could be a latent risk, but for the time being has not caused trouble.
There are several reasons a Trump administration has caused inflation concern:
- From a cost-push perspective, tariffs are generally seen as inflationary, as they increase the cost of imports. Deportation and tighter immigration policy could lead to tighter labor markets and higher wages. Similarly, significant infrastructure spending could stress an already limited supply of construction labor, driving wages up in that sector.
- From a demand-pull perspective, tax decreases and fiscal stimulus could push the economy beyond its current capacity.
- Finally, from a monetary point of view, higher debt levels and the possibility of foreign countries seeking to reduce their US bond holdings could all lead to higher nominal rates and inflation.
There are counteracting effects, of course (such as the disinflationary impact of a stronger dollar), and at Plum Street Advisors we believe it is too early to predict significantly higher inflation. However, there are a larger number of inflation risks in the market.
So why not just wait and see? Because the real risk to your assets is changes in unexpected inflation. Once inflation becomes expected, it is very quickly priced in to asset values and interest rates (as we’ve seen in the days since the election). In fact, market returns do not seem to be significantly correlated one way or another to the realization of expected inflation, but are clearly highly negatively correlated to unexpected inflation shocks.
Protecting a Portfolio Against Inflation
There are assets that have traditionally done well during periods of unexpected inflation. Which assets will do best in any particular episode can depend on the source of inflation, and it is generally best to diversify among hedges.
There are several ways to look at the effectiveness of an asset class as a hedge. We often talk about correlation – in this case, assets with a strong correlation to inflation will tend to go up when inflation goes up, and down when inflation goes down. But to understand the magnitude of the expected move, you need to look at betas:
Figure 3: Asset Class Sensitivity to Unexpected Inflation
*Estimated using data from January 1970 through June 2012, or a sub-period for any indices with shorter history
Source: Mellon Capital (used with permission)
For example, cash will have a high correlation to inflation, because the returns to cash will tend to go up along with inflation. However, if inflation goes up by 1%, the cash asset’s return might be expected to go up by 1% as well, implying a beta of 1. Real assets have historically had a beta higher than one, meaning that if inflation goes up by 1%, real assets go up more than 1%. For example, as can be seen above, energy commodities have historically had inflation betas of over 10, suggesting a less than 10% allocation would have protected the entire portfolio.
Overall, commodities and commodity sector equities tend to be the most sensitive asset class to inflation, and will often provide the greatest protection to your portfolio. However, commodities offer lower real return in the long run compared to equities (in the very long run, the price of commodities have basically tracked inflation). A recent study called “Are Commodity Futures a Good Hedge Against Inflation?” (Spierdijk and Umar, 2013) confirmed again that although there is notable inflation hedging to be gained from investing in commodity futures (especially energy, industrial metals, and cattle), there is also a negative impact on expected returns. (Also, interestingly they did not find precious metals to be a particularly good inflation hedge, contrary to popular belief)
Real estate has generally had stronger returns than commodities, but it offers somewhat less inflation protection. Real estate has been shown in studies to track more closely to the S&P 500 than other inflation hedges, especially in the short run. However, in the longer run real estate does offer significantly better inflation hedging than the overall stock market.
Treasury Inflation Protected Securities (TIPS) are still somewhat new and we can not look back all the way to the 1970s to analyze their track record. Still, their construction would suggest that they will provide a good alternative to regular bonds for protection against unexpected inflation, since they are adjusted subsequently for actual realized inflation. The price of TIPS have recently risen versus nominal bonds, and are now pricing in inflation of approximately 1.8% over the next 10 years at the time of this writing. If inflation ends up being considerably higher than that, TIPS will protect the assets invested in them (but will not provide “extra” protection for other assets since their value will not increase more than the rate of inflation).
Implications for Your Portfolio
At Plum Street Advisors we do not generally advocate tactical timing in your portfolios. However, as part of our strategic allocation advice we do look out to the longer term, and as new risks arise we want to ensure that portfolios are properly protected from those risks. Recent changes have, in our opinion, slightly increased the risk of inflation which remains admittedly low in the current environment compared to historical levels. We recommend watching these closely and making an informed judgement of whether the cost of slightly lower probable returns is prudent in order to generate more inflation risk protection.
A critical factor in making this determination will be the inflation sensitivity of the investor. Many factors can impact this, such as:
- A younger investor has the advantage of significant inflation-adjusted earnings still coming to them, and should be less concerned about inflation.
- An investor in equities may be better positioned in the medium term than an investor in nominal bonds, because existing nominal bonds will fall in value as nominal rates increase.
- An investor whose bond portfolio has a lower duration will be less exposed to rapid changes in interest rates than someone with a bond portfolio with longer duration.
- Someone who has a home (and a mortgage) has more of their total wealth in inflation-sensitive assets than someone who has a smaller home, no mortgage, or rents their home.
- Finally, an investor that can hold commodities in a tax-exempt portfolio will be able to more efficiently add this asset class, due to the less-favorable tax treatment of commodities than other investment classes.
For certain investors, an allocation to real assets like TIPS, real estate, and commodities can offer inflation protection as well as overall diversification to reduce portfolio volatility. Other ways to reduce inflation risk in a portfolio include shortening your bond durations, diversifying internationally, or even holding more cash. We recommend talking to your advisor to find the best choice for your portfolio.