15 December 2020
Author: Gavyn Davies, Executive Chairman
With optimism rising about the roll out of Covid-19 vaccines, financial markets have been gripped by a global “reflation” trade, implying faster growth in nominal gross domestic product and company profits.
Inflation is anticipated to remain well below central bank targets for the next two years. However, US inflation expectations are rising and huge increases in public debt and central bank balance sheets are causing many investors to think seriously about how to protect their portfolios from inflationary risks.
A recent note by Fulcrum economists argues that this is no easy task — so how can it be done? A portfolio shift away from conventional bonds into equities might seem appropriate, because equities might benefit from an increase in the inflationary element of corporate earnings.
In the very long term that should work, but the time span needs to be measured in many years. Over shorter periods — which matter greatly to many investors — unexpected inflation is often bad for equities because it leads to tighter monetary policy, rising real interest rates and future recessions.
Peter Oppenheimer of Goldman Sachs has shown that an unexpected rise in US inflation above 2-3 per cent usually harms equities, eliminating their value as an inflation hedge just when it is most needed. The same can be true of some other assets, such as real estate.
During the great inflation shock of the 1970s, global equities and bonds suffered in tandem. Standard US portfolios, holding 60 per cent equities and 40 per cent conventional bonds, produced real returns of minus 1.5 per cent a year during the entire decade. In the first three years of the inflation shock from 1971-74, investors lost 10.5 per cent a year in real terms in these portfolios.
A repeat of such disastrous events seems improbable, but that unlikely risk is what tail protection for portfolios needs to address. Inflation-protected government bonds (Tips) were introduced in 1981 in the UK, and 1997 in the US, for precisely this purpose. If held to maturity, these provide a return equal to the current real bond yield plus the actual rate of inflation. They are free of default risk, even in the case of hyper inflation, so are good long-term hedges against inflationary Armageddon.
However, investors have already taken note of these advantages, so real yields on these bonds have been driven heavily negative. Ten-year index-linked bonds now offer real yields of minus 0.9 per cent in the US, and minus 2.9 per cent in the UK — that is a hefty insurance premium to pay.
Furthermore, while Tips offer excellent protection against very high inflation in the long term, over periods shorter than the time to maturity, they can be extremely volatile because real yields can change sharply. A rise of 1 percentage point in the real yield on 10-year Tips from today’s extremely low levels would reduce the market value by about 10 per cent, imposing a mark-to-market loss on existing holders. Investors should therefore consider other hedges. Sudden periods of rising inflation, even outside the 1970s, have frequently coincided with oil price surges.
Direct exposure to the energy complex, for example through oil futures or exchange traded funds, is therefore likely to bring high returns at such times. Gold may have similar advantages, though quarterly correlations with inflation have faded since the 1970s.
Another option would be short-dated Treasury bills, or floating-rate debt. This may seem counter-intuitive, since the value of near-cash assets would be rapidly eroded by inflation if short-term interest rates remain fixed. However, short term rates are in fact likely to rise sharply under conditions of a severe inflation shock, because central banks are bound by their inflation targets to tighten monetary policy.
In summary, a combination of Tips held to maturity, commodity-related assets and short-term Treasury bills is likely to offer reasonable protection against inflation shocks.
But these hedges need to be actively managed, since their performance would be affected by the specific characteristics of any inflation shock. Furthermore, inflation hedges — like any other form of insurance premium — are costly, reducing asset returns when inflation remains under control.
Reducing inflationary tail risk is certainly not a free lunch.