Given some of the hysteria provoked by the current political environment, it is somewhat of a surprise that few – whether gold bugs or vehement Trump critics – have mentioned hyperinflation.
After all, the inflation rate has more than trebled in little over six months: from 0.8% in July to the latest reading of 2.7% in February, the highest level since 2012.
Alarmism is admittedly far from justified: much of the spike is due to the recovery in oil prices and the Federal Reserve has noted that core inflation – which excludes the more volatile components of the price index – has been lower and steadier. The Federal Open Market Committee still expects core inflation to stabilize around 2% ‘over the next couple of years.’
Investors can prepare for a more inflationary regime without panicking, though. QMA, part of Pgim, acknowledges that the double-digit price increases of the 1970s are unlikely to be seen anytime soon, but insists investors should not dismiss inflation hitting 4-5% by the end of the decade.
Fortunately for investors, a wide range of assets have historically fared well with inflation and are now available as liquid funds. In new research, QMA focuses on eight: US real-estate investment trusts (Reits), international Reits, Treasury inflation-protected securities (Tips), commodities, master limited partnerships (MLPs), global infrastructure, natural-resource equities and gold. These can loosely be grouped together as ‘real’ assets for their tendency to generate positive returns after inflation.
To test the thesis, QMA created a portfolio with an equally weighted allocation to each of these eight assets and examined its performance during inflationary periods.
Between March 1997 and December 2016, there were 111 months in which inflation was above the historical average of 2.15%. The portfolio of real assets produced an average annual return of 8.7% during those months, ahead of the 3.3% from a traditional 60/40 stock-and-bond split.
The real portfolio also did well in periods when nominal bond yields rose and the Fed hiked rates, often adjuncts to inflation. In the four instances when bond yields rose by more than 100 basis points from trough to peak over the past 20 years, the portfolio outperformed a 60/40 allocation by 330 basis points. And on the two occasions in that time when interest rates were moved at least 100 basis points higher, the real assets outperformed by 1,060 basis points.
Accepting that a portfolio solely consisting of real assets was inadvisable, QMA considered the effect of a 20% weighting to such securities as well. This allowance boosted annual returns over the full two decades by 29 basis points and also enhanced the portfolio’s Sharpe ratio from 0.74 to 0.78.
Every time is different
Of course, as QMA highlighted, inflation is not a monolithic phenomenon and its different iterations have different implications. The inflation experienced from February 2007 to October 2008, for example, featured oil surging from $62 to $140 a barrel on optimism about China’s growth path before slipping back to $67 with the financial crisis, while Reits suffered and gold shone.
A strategic allocation to real assets that tilts tactically according to the underlying conditions can thus add value. So how is QMA positioned for inflation today?
Edward Campbell, managing director and portfolio manager at the firm, confirmed he has skewed more toward the commodity asset classes over the past 12 months. This has come at the expense of real estate, which he believed had become expensive and faced headwinds from rising interest rates.
Campbell has also lowered his allocation to Tips and increased exposure to short-duration credit to its highest permitted portfolio weighting. ‘In general, we would rather be taking credit risk than duration risk in the portfolio because of our view that economic growth is going to remain healthy and interest rates are going to be rising,’ he explained.
On the commodity side, Campbell has opted for active managed futures rather than ETFs as his preferred vehicle. ‘The reason we are focused on an active managers rather than just buying an exchange-traded fund is because the shape of the futures curve is important within commodities,’ he commented. ‘If commodities are in contango versus backwardation, there is a negative roll yield, so the value of active management in considering the shape of the futures curve and its impact on returns is worth it.’
Campbell is positive on MLPs too. ‘It’s an environment where it’s difficult to find asset classes that are cheap, but we think when we look at MLPs and their yield spreads relative to Treasuries or corporate bonds, they still look attractive.’