Some background on inflation
After decades of policymakers favoring low inflation, often at the expense of higher-than-necessary unemployment1, recent events suggest that we may be witnessing a regime shift. The Federal Reserve under Chair Jerome Powell has clearly communicated that it intends to place more weight on the full employment side of its dual mandate than it has in recent decades, leading to historically loose monetary policy2. After enacting stimulus of historic proportions via the $1.9 trillion American Rescue Plan Act (ARPA), the Biden Administration has set its sights on expansive infrastructure spending to address the US’s immense backlog of deferred investment in roads and bridges3 and supercharge the country’s efforts to address the intensifying climate crisis. This potent combination has some experts and more than a few market participants concerned4 that inflation could rise to levels that would adversely affect investors’ portfolios, which have long eluded inflation’s sting.
So what is inflation exactly? Most of us know that inflation is defined by a general rise in prices. Many of us are even aware that there are multiple measures of inflation, the most well-known in the US being the Bureau of Labor Statistics’ Consumer Price Index for All Urban Consumers (i.e., CPI). This is the most commonly cited metric, and the Treasury Department uses the non-seasonally adjusted flavor of this index to adjust the principal of Treasury inflation-protected securities (TIPS) to which the fixed coupon rate is applied. The Social Security Administration also uses a variant of this metric to determine beneficiaries’ cost-of-living adjustments. Since 2000, however, the CPI has not been the Fed’s preferred measure of inflation when setting monetary policy.
When it comes to the work of the Fed’s Federal Open Market Committee (FOMC), the Bureau of Economic Analysis’ Personal Consumption Expenditures Index (PCE) has been the globally preeminent central bank’s preferred metric since the turn of the millennium (though it will consider others)5. At that time, the Fed cited the PCE’s flexible weighting scheme that accounts for substitution, “which avoids some of the upward bias associated with the fixed-weight nature of CPI.” The PCE index also accounts for the expenditures of urban and rural populations, as well as expenditures made on behalf of consumers; for example, “CPI only accounts for out-of-pocket medical expenses, PCE tracks expenditures made for consumers, thus including employer contributions” to medical plans6. These are just some of the major differences between the two metrics—there are many more—but they get at why divergences exist in the two measures over time (see the graph below). Although these series are correlated (since they are measuring the same underlying phenomenon, after all), these small differences can add up quickly, given the sheer scale of benefits and interest payments tied to one metric or another.
Where we stand
As vaccinations rise and COVID-19 cases fall, the US economy is in flux as it transitions to a new normal. Having been locked up for much of the last year, consumers are starting to spend freely on travel and leisure activities, whereas the sectors providing these services are having to ramp up capacity after steep declines in demand. This state of affairs recently has entailed substantial inflation volatility as outright deflation falls out of year-over-year prints. Most recently, April’s year-over-year CPI figure printed the biggest jump since 2008, while wholesale producer prices, as measured by the BLS’ Producer Price Index, also have increased significantly (see the chart below).
Although we do not have April’s PCE print yet, it is clear that prices are on the upswing. Many of these increases can be attributed to “base effects” that reflect year-over-year growth from unusually weak price data when the economy ground to a halt in the initial wave of COVID-19 rather than from genuine and durable inflationary pressures. Additionally, supply side constraints, such as low inventories7, chip shortages8, and misplaced container ships (and sunken containers)9 are all contributing to bottlenecks in global supply chains and disequilibria in supply and demand. In the medium term, however, little evidence exists that these factors will outweigh more secular disinflationary factors, such as globalization, technological innovation, ongoing weakness in organized labor, and aging demographics in the developed world. More immediately, the state of the labor market also suggests that we still have a ways to go before we see overheating aggregate demand (see the BLS’s employment-to-population chart below). Given this backdrop, the Fed has remained steadfastly dovish to support the economy as it recovers from COVID-1910.
The Fed’s view is that recent price increases are likely to be transitory. However, investors benefit from diversifying the risks in their portfolios, and protecting against inflation is a prudent move. Rising prices can have a deleterious effect on the major asset classes that typically comprise the majority of an investor’s portfolio, particularly income-dependent investors in the decumulation phase of their investment life cycle. Furthermore, the dearth of inflation in recent years likely has left many investors inadequately hedged against the possibility of higher prices, particularly higher-than-expected price spikes.
So how can investors hedge inflation?
As with so much in the world of finance, the current value of an asset or metric is often less important than an unexpected change to it, and inflation is no different. At a given level of inflation (or inflation expectations), stocks and bonds reflect the market’s views via their prices and yields. However, because change in inflation expectations typically have negative price implications for stocks and bonds, investors may want to consider other asset classes that perform better during inflationary spikes. In the table below, Cohen & Steers, a global asset manager focused on listed real assets (real estate, infrastructure, and natural resource equities), assesses how different asset classes have performed in periods of unexpected inflation from 1991 through 2020.
DWS recently performed a similar analysis focused on a more limited temporal data set (2003-2020) with different index choices, but the conclusions largely align with one another.
In both of these analyses, it is clear that traditional nominal bonds (i.e., those without explicit inflation adjustments) and equities tend to underperform real assets and commodities when inflation spikes unexpectedly. However, these pro-inflationary asset classes are distinct from one another. As DWS opines, “while commodities and natural resource equities have historically delivered the greatest inflation protection, we believe global infrastructure and real estate may provide attractive portfolio enhancing attributes through a combination of cash flow and dividend stability compared to traditional global stocks and bonds. The revenue sources for infrastructure and real estate are predictable due to long-term contractual agreements that often allow these companies to pass on higher costs from inflation, resulting in real earnings growth11.” In other words, global real estate and infrastructure have not historically provided the inflation-hedging characteristics of commodities and natural resource equities, but their return streams are also not as cyclical and dependent on commodity prices.
In summary, listed real assets, commodity producers, and commodities themselves can provide investors with protection from unexpected inflation, thereby reducing inflation risk and increasing the real return of their portfolios over time.
This commentary is intended for investment professionals only. All macroeconomic data is obtained from Bloomberg. This commentary is provided for educational purposes only. The information, analysis and opinions expressed herein reflect our judgment as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. All investments carry a certain risk and there is no assurance that any investment, asset class or factor subset will provide positive performance over any period of time. Information obtained from third party resources are believed to be reliable but not guaranteed. Past performance is not indicative of future results.