FRANKLIN TEMPLETON THINKSTM INFLATION

Protecting portfolios against inflation

Gene Podkaminer, CFA Wylie Tollette, CFA, CPA Laurence Siegel1

November 2019 Protecting Portfolios November 2019 Against Inflation

Why portfolios need to be protected against inflation Inflation, fast or slow, seems to be a fixture in our fiat- money system. Today, inflation is running at a mild rate near 2% per year, a rate low enough to escape some investors’ notice—but 2% inflation is still inflation. At that rate, prices double every 35 years and rise more than sevenfold in a century. Moreover, inflation isn’t guaranteed to remain that low. In the lifetime of the authors, it has ranged as high as 13%, a rate steep enough to severely damage any portfolio that is not properly protected against inflation.2 It could happen again.

Inflation also directly affects liabilities. Whether the liability is a legal obligation, such as with a defined-benefit (DB) pension plan, or a concep- tual obligation such as the need to fund one’s retirement or the spending plans of an endowed institution, inflation flows through to liabilities in a way that must be accounted for when setting investment policy.

The “stagflation” of our youth, if you’re of a certain age, turned to “doefla- tion” (Peter Bernstein’s memorable wisecrack) so long ago—sometime in the 1980s—that it can be hard to focus on the necessity of protecting portfolios against inflation, both anticipated and unanticipated (a distinc- tion we’ll clarify below). In this paper, we reaffirm the importance of understanding and protecting against inflation shocks, assess what is likely to influence inflation rates in the future, and identify asset classes and strategies for defending the real value of assets against erosion by inflation.

In an earlier work, two of us said, “Inflation is a ninja. A shock to global growth will flatten you, but you will see it coming…[But] inflation will kill you in stealth. It can creep up on you year after year. If you’ve counted on 3% inflation on your asset side and that’s what you targeted to achieve, but your obligations are increasing by 4%, that may not look like a lot over any given year. Over 10 years, however, that will create a real funding problem.”3

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Inflation and real interest rates This paper is a companion to our “Real Interest Rate Shocks and Portfolio Strategy” (September 2019). Inflation and real interest rates, as concepts, are joined at the hip. One has little meaning without knowledge of the other. They sum to the nominal interest rate, which (for US Treasury bonds) is the most important observable variable in finance. (The other “most important” variable, the equity risk premium is not observable.)

But it is unwieldy to deal with these very different risks in a single paper. We chose to divide protection against real interest rate shocks and protection against inflation shocks into two papers because they are distinct risks with dissimilar origins and different future prospects.

What is inflation? At the most basic level, it’s a tax To sum up, the cost of government is set by its spending and We tend to be monetarist in our macroeconomic orientation and is the same whether it’s financed through current taxes, agree in principle with Milton Friedman’s classic statement that borrowing, or inflation (debasement of the currency). It’s only a “inflation is always and everywhere a monetary phenomenon.”4 small leap to say that’s why we have inflation. Inflation can But circumstances have changed and what Friedman meant by be regarded as a means by which the government can spend the money supply no longer applies. A group of economists more than its current income. It’s a tax. with monetarist foundations has developed a “fiscal theory of the A Very Simple Macro Model price level” that acknowledges the links between fiscal and As we go into detail on the monetary and macroeconomic founda- monetary policy, while maintaining that inflation principally arises tions of inflation and how they can be used to form a view from actions of the sovereign rather than in the real economy. on inflation, we’ll refer to the Very Simple Macro Model (VSMM) We’ll develop these themes further in subsequent sections. introduced in “Real Interest Rate Shocks and Portfolio Strategy.” Principles of public finance This non-mathematical, entirely verbal model says that, in Whatever your political orientation, the following basic economic the short to intermediate run, the primary driver of macroeco- principle applies: when a government spends money, or more nomic change is the tension between the real business cycle and precisely uses a real economic resource, it has to get the the government’s attempts to manage the economy. We’d add resource from somewhere. There are only three possible sources: that, although it’s not in our original VSMM, in the long run, past taxation, current taxation, and future taxation.5 You know macroeconomic trends are driven by demographics and produc- what current taxation is; it’s what you pay to the tax authority. tivity growth rates. Future taxation is what will be required as a consequence of the government borrowing money; government debt is just Anticipated and unanticipated inflation taxation deferred. Economists and fixed income analysts divide inflation into two parts: (1) anticipated inflation, the part that is already But how do you tax the past? The answer is by reducing the real incorporated into the prices of bonds and other assets; and (2) value of savers’ balances. Savers’ balances are the accumulated unanticipated inflation, the “shock” or “surprise” term. fruits of past labor. When inflation occurs, those amounts of Protecting the portfolio against these two components of inflation money buy less. We can thus regard inflation as simply a tax requires different kinds of thinking and different strategies. on savings, where the government pays off its old debts in cheap- We will maintain this distinction, where relevant, in this paper. ened dollars, effectively defaulting on the debt in real terms although not in nominal terms.6

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Finance theory says that portfolios are already protected against • In the short run, increases in inflation usually hurt stock prices the anticipated part of inflation, because it is in the price due to increases in the discount rate or interest rate as well of all assets. While that may be mechanically true for bonds, it is as impairment of corporate profits in real terms. Thus, stocks a more speculative concept for other assets such as stocks and are a plausible inflation hedge only for the longest-term real estate. We’ll take this consideration into account as we investors, those who can wait for a disinflationary period (if it enumerate the typical asset-class components of a portfolio and occurs) after inflation rates have peaked. describe their likely response to both anticipated and unantici- • For a US investor, non-US stocks are a potential hedge pated inflation. against a US inflation shock (Rödel 2014), partly because of the foreign currency exposure. Principal findings Before getting into our in-depth analysis, we present our Alternative assets principal findings: • Real estate is a traditionally good hedge against inflation. In particular, residential real estate values tend to rise with Bonds incomes. The relationship is not perfect, as we saw with • The conventional wisdom that bonds are a poor (or negative) the housing bust in 2007–2009, which took place under hedge against inflation shocks is correct, for mechanical conditions of mostly stable and positive inflation. reasons: an increase in interest rates caused by an increase in inflation expectations causes bond prices to fall. • Commodities are another traditional inflation hedge and are negatively correlated to growth assets (equities) but are • However, if the inflation shock is one-time, and a new, higher extremely volatile and investors should exercise caution but stable inflation rate is established, the new, higher yield of investing more than a small fraction of the overall portfolio the bond compensates for the higher inflation rate and the real in them. return of the bond going forward is similar to what it was before. The shock is reflected in a one-time loss of value. • The categories of hedge funds and private equity are too broad to have any generalizable inflation-hedge characteristics. • Inflation-indexed bonds, such as Treasury Inflation-Protected It depends on the particular investment. Securities (TIPS), are a near-perfect hedge against inflation shocks. The problem is their low real yields. Liabilities and asset-liability portfolios • “Real” liabilities, such as DB pension funds with a cost of Equities living adjustment (COLA), are highly vulnerable to inflation • The relationship between inflation shocks and equity returns is shocks. They increase in present value (that is, the cost to pay complex. Conceptually, equities as a class are real assets them off) as inflation rates rise. Thus, they are best hedged (claims on factories, trucks, patents, labor contracts, and so with long-duration TIPS and other long-duration inflation hedge forth) and are intrinsically inflation-protected. Empirical assets, such as real estate and certain equities. evidence from the one major inflation shock in the US in the past, however, shows the opposite relationship: inflation hurts • Purely nominal liabilities, such as the obligation to pay off a stocks, at least in the short and intermediate runs. fixed-rate corporate bond or mortgage, benefit from inflation (that is, they cost less to pay off in real terms). • Different stocks react differently to inflation shocks. A company that easily can pass cost increases on to its • If an asset-liability portfolio contains real liabilities and mostly customers is much better protected against inflation nominal or fixed-rate assets, which is not an uncommon shocks than a company that cannot. Thus, careful active situation, it is highly vulnerable to inflation shocks and the management may benefit investors who foresee an hedge can be improved by replacing some of the fixed-rate inflation shock. assets with inflation-hedge assets.

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Development of the ideas

Some brief history: Inflation? What inflation? By the way, consumer prices rose more than 19-fold (to be People have short memories. If we can’t remember what we had precise, by 1,959%) over the period shown. Over the postwar for lunch yesterday, should we be expected to remember (1946–2019) period, they rose by 1,307%. Since the cooling inflation rates from more than 20 years ago? Exhibit 1 provides of the inflationary fire in 1982–1983, they rose 162%. a refresher course. Inflation is not something that can be ignored or assumed to have been tamed. Today, inflation appears to be baked into the cake at about a 2% annual rate—a little less during the Great Recession, a little Expected and unexpected inflation: Pitting debtor more in the booming nineties, more than two decades ago. against creditor The wild inflations and deflations in Exhibit 1 seem like some- As you probably guessed from the history in the previous section, thing our grandfather would complain about. much of the inflation in the late 1960s and all of the 1970s But the real lesson of Exhibit 1 is that “anything can happen.” was unexpected; that is, it was not built into the prices of assets. Starting about 1983, inflation has been reasonably well-behaved, It was a surprise—a pleasant one if you were a debtor, who but that is not a long enough period to justify complacency. could pay off debts in cheaper dollars, and a very nasty one if We have not worked out all the kinks in the system, as the Global you were a creditor (saver) on the receiving end of the cash flows. Financial Crisis showed mercilessly. That crisis involved a Likewise, much of the disinflation of the 1980s, 1990s, and collapse in real output and asset prices while consumer prices the first two decades of the current century was unexpected and remained stable. The next financial crisis, however, could be a resulted in a massive windfall for savers. Unlike expected highly inflationary or even a deflationary one. inflation, then, unexpected inflation rearranges the terms of

THE LONG-TERM HISTORY OF INFLATION IS ONE OF GREAT VOLATILITY, NOT STABILITY Exhibit 1: US in ation rates (Consumer Price Index-U), year-over-year, calculated monthly January 1872–June 2019 25

20

15

10

5

0

-5

-10

-15

-20 Jan Sep May Jan Sep May Jan Sep May Jan Sep May Jan Sep May Jan Sep Jun 1872 1880 1889 1898 1906 1915 1924 1932 1941 1950 1958 1967 1976 1984 1993 2002 2010 2019 Source: Franklin Templeton Capital Markets Insights Group, U.S. Bureau of Labor Statistics (BLS), Shiller, Macrobond. August 2019.

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contracts (or at least those expressed in nominal terms) between But we investors do not control the inflation rate or the policies debtors and creditors. It is thus destructive to capital formation, that help to determine it. So, we must protect our clients’ because capital suppliers don’t know whether they will be portfolios against unwelcome surprises that might destroy signifi- paid back in sound or depreciated money. The recessions of the cant portions of their capital. 1970s, especially in the US and the UK, have been described as a “capital strike”7 by investors or savers who preferred to Inflation, asset returns, and liability returns consume instead of saving, or simply not work very hard, rather In “Real Interest Rate Shocks and Portfolio Strategy” we than risk their capital in what looked like a losing proposition. described the sensitivity of asset prices to changes in real interest rates and in inflation using the language of “duration.” A cross of gold? This concept comes from the world of bonds, where duration Of course, those who benefit from unexpected inflation, debtors, is (as the word suggests) a measure of time, specifically the pres- can be expected to clamor for as much inflation as possible. That ent-value-weighted average time to receipt of the cash flows is the reason for the now mostly forgotten, but very important, from the bond. But sensitivity, or price elasticity, is a broader and historical episode in the US in the 1890s wherein farmers and more general concept and we use it here to refer to the change other debtors campaigned to abandon the gold standard in favor in the price or value of any asset, or of a liability, in response to of a looser “bimetallic” (gold and silver) standard that would the change in some variable (here, inflation). cause prices to rise.8 “You shall not crucify mankind upon a cross of gold,” thundered the young Nebraska congressman William By the way, we use the word liability to mean not just the legal Jennings Bryan in 1896. Translation: allow debtors to pay back liability of a pension fund, but also a retiree’s or institution’s creditors with cheaper money. Renege on their debts in real spending needs, which have the economic characteristics of a terms while honoring them in nominal terms. liability. See “Real Interest Rate Shocks and Portfolio Strategy” for a discussion of why it is important to understand the Navigating the “Ph.D. standard” liability and to manage the assets and liabilities together as a We face a similar situation today, although with US Federal single portfolio, rather than managing the assets in isolation. Reserve (Fed) policy, not gold and silver, as the political football. (The bond analyst Jim Grant has satirically described control If an asset has an inflation sensitivity of zero, then, its price of the money supply by central banks, staffed largely by holders does not move at all when inflation rates or inflation expectations of Ph.D. degrees, as a “Ph.D. standard,” in contrast to a gold change. If it has an inflation sensitivity of, say, –10%, then or other monetary standard.9) Inflationists include those the asset price can be expected to fall by 10% when the inflation who would have governments borrow in expensive dollars and pay rate rises by one percentage point.10 Because these sensitivity back in cheap ones, but they are not the only inflationists. estimates are inexact by their very nature, in the following Homeowners, too, want to pay back their mortgages in cheap analysis we express them as directions (very negative, negative, dollars and many of them are relying on inflation at rates greater near zero, positive, and so forth) rather than numerical estimates. than 2% to justify the prices they paid for their houses. And Exhibit 2, on the next page, shows directional estimates of the indebted corporations may also favor high rates of inflation for inflation sensitivity of the principal asset classes along with that the same reason. of a 60/40 portfolio, a representative liability, and a hypothetical Anti-inflationism is mostly found among savers and fixed income asset-liability portfolio that is fully hedged against the risk of investors, central bankers tasked with maintaining the soundness inflation surprises. Note that the sensitivity does not have to be of money, and seniors. Who cares about them? positive for an asset to be a good inflation hedge; a zero O( ) denotes an asset that moves one-for-one with inflation and is We all should. The rate of productivity growth is the most thus a theoretically perfect inflation hedge (although no hedge is important determinant of long-term economic performance, and ever perfect in practice). productivity growth depends on technological change and capital (including human capital) accumulation. These factors Inflation shocks and asset returns rely on stable prices or, if not literally stable prices, then low and In this section, we review each major asset class (plus liabilities) predictable rates of inflation. Inflation surprises are destructive and indicate how it can be expected to respond to inflation shocks, to capital and should be avoided. that is, changes in current inflation or in inflation expectations.

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SENSITIVITY TO INFLATION VARIES WIDELY AMONG test various hypotheses. More recent data do not contain much ASSET CLASSES variation in inflation, so it’s hard to draw conclusions about the Exhibit 2: Real interest rate sensitivity of principal asset and impact of inflation on asset prices after about 1983. liability classes* Inflation sensitivity Using ordinary logic, which is usually the best way to begin to Assets Fixed Income Cash O assess an economic situation, the real value of a firm should have 10-year Treasury Bonds GG nothing to do with inflation. Firms are in the business of buying 10-year TIPS O real assets—factories, trucks, labor contracts, patents—and 10-year Credit GG selling real assets (consumer or producer goods and services). Global Equities Public G (Short Term) However, in practice equity markets have responded very ≈O (Long Term) negatively to unexpected inflation and very positively to declines Comments: Works for normal range of inflation, say 1–6%; above that, effect more variable. in inflation. As shown in Exhibit 3, the period from 1966 to 1982, when inflation accelerated greatly, was one of the worst Private G (Short Term) periods in history for stocks. The disinflationary period after that ≈O (Long Term) Comments: This relationship may be obscured by was one of the best. smoothing due to appraisal-based valuation. Works for normal range of inflation say 1–6%; STOCKS HATE ACCELERATING INFLATION AND above that, effect more variable. LOVE DISINFLATION

Exhibit 3: S&P 500 index (price only, in constant 1990 dollars) Real Assets Real Estate O (Unleveraged) A (Leveraged) versus annual Consumer Price Index (CPI) in ation January 1941–August 2019 Commodities A (Short Term) Real Equity Index (Level. Log scale) Year-over-year change in US CPI (%) / O (Long Term) G 10,000 25

Liabilities DB Pensions with no COLA GG 20 DB Pensions with COLA ≈O 15 Individual Savings—25-year Horizon O Endowments and Foundations O 1,000 10

Sovereign Wealth Funds Natural Resource 5 Related** 0 Fully Duration Hedged Asset-Liability Portfolios O Source: Franklin Templeton, for illustrative purposes only. Directional estimates by 100 -5 the authors. For background information, see: Attié and Roache, 2009; Strongin and Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Aug Petsch, 1997. Full source in bibliography. ’41 ’47 ’54 ’60 ’67 ’73 ’80 ’86 ’93 ’99 ’06 ’12 ’19 *Note: An up arrow indicates the asset moves up more than the consumer price level, Real (in ation-adjusted) level of S&P 500 equity index (Shiller) a double up arrow indicates much more. A down arrow indicates the asset moves United States, CPI, All urban consumers, US city average, down when consumer prices go up, a double down arrow indicates the asset moves down All items (year-over-year change) even more when consumer prices go up. A zero indicates inflation has no effect on the real value (i.e., the nominal price of the asset goes up the same as inflation). Source: Franklin Templeton Capital Markets Insights Group, US Bureau of Labor Statistics (BLS), S&P/Robert Shiller, Macrobond. August 2019. **The liabilities of a SWF are not particularly driven by real interest rates but by the dynamics of the market for whatever natural resources the SWF was established to hedge against. If oil prices go up, Qatar wins (in terms of GDP) and Singapore loses. So Qatar’s Academic research future needs (liabilities) go down and Singapore’s go up. The transformation of inflation in the 1970s from a background hum to a lion’s roar, and the accompanying bear markets, Equities spawned a vast literature on equity returns and inflation. The The most influential work on inflation and asset returns, include consensus up to that time had been, as Zvi Bodie wrote in 1976, equities, was done by Zvi Bodie, of Boston University, in the that “[e]conomic theorists…long considered common stocks 1970s and 1980s in response to the wave of inflation taking an inflation hedge…because stocks represent ownership of place at that time. While these studies are quite old, they cover a physical capital whose real value is assumed to be independent period when inflation rates varied greatly, making it possible to of the rate of inflation. This independence implies that a

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ceteris paribus change in the rate of inflation should be The rise in the discount rate, then, was not the only cause of the accompanied by an equal change in the nominal rate of return bad performance over 1966–1982. Profits were also weak. S&P on equity.”11 earnings were $43.28 (in July 2019 dollars) in 1966, a boom year, and $33.23 in 1982, a recession year (the previous peak But Bodie then presents powerful evidence to the contrary. earnings having been $49.71 in 1979). We conclude that compa- He summarizes his results: “[C]ontrary to a commonly held nies were very poorly hedged against inflation in this period, belief…the real return on equity is negatively related to both and we are concerned that, because rapid inflation is such anticipated and unanticipated inflation, at least in the short run. a distant memory, they might be poorly hedged in the future. This negative correlation leads to the surprising and somewhat disturbing conclusion that to use common stocks as a hedge Bonds, TIPS, and cash against inflation one must sell them short.”12 Nominal bonds Bodie’s conclusion has been reiterated in most of the literature Anticipated inflation (the inflation rate that is embedded in the since that time.13 The remaining questions are: (1) what about yield of the bond when issued) should have no effect on disinflation? Do the huge equity returns during the disinflationary bonds. Mathematically, all other things being equal, if the initially period 1982–1999 “give back” to investors the real capital anticipated inflation rate continues for the life of the bond, they lost during the run-up of inflation rates prior to that time? the bondholder will get exactly the real return he or she expected And, (2) are the patterns in the Great Inflation and the subse- when buying it. quent disinflation typical and repeatable, or one-off? In reality, things don’t work out quite so neatly because real Small sample problems interest rates fluctuate, creating a small amount of reinvestment The problem with this analysis is that it is of a sample of one. risk. So, the mathematical principle we just described is Except in wartime, nothing like it ever happened before in exactly right only for zero-coupon, original-issue-discount bonds US history so we cannot get the sample size up by going farther (which are the “pure” form of a bond). But the principle back in time. But the fiscal and monetary dynamics that works pretty well for ordinary, par or close-to-par bonds. prevailed over this period are likely to resemble those that would Unanticipated inflation is terrible for bonds, representing as it prevail in a future inflationary episode, so we can say with does the borrower paying back a debt in dollars that are some, but not total, confidence that equities are a less than cheaper than originally expected. The shorter the maturity of the perfect inflation hedge except over the very longest run. bond, the less terrible unanticipated inflation is. This is Unanticipated inflation, then, is bad for equities, and disinflation because, as bond yields rise with inflation, the investor in a short- is very good for equities. Low and stable inflation rates are er-maturity bond can reinvest bond proceeds (coupons and sometimes described as being ideal for equities, but those were principal) at the new higher rate, lessening the impact of the the conditions in the period 1999–2014, which had poor unanticipated inflation. equity returns, so we cannot really generalize and say low and Exhibit 4 on the next page shows the real total return from stable inflation rates are always good. a constant 20-year and constant 5-year maturity portfolio What causes the negative relation between inflation and of US Treasury bonds from 1950 to 1999. Note that the return stock prices? shown in the exhibit is not the bond’s price, as in Exhibit 3— The seminal research on inflation and equity prices shows a it’s the total return, including the coupon. double whammy on equities: (1) higher nominal discount rates, We choose this period because it includes a period of very little, and (2) the fact that companies cannot always raise selling then high, then negative unanticipated inflation. We see that, prices enough to compensate for their rising wage and other for a supposedly safe asset, the first part of the period (through costs. Companies that can raise prices fare better in an inflation; 1982 when yields peaked) was a catastrophe for holders of we saw this with oil stocks in 1979–1980, where huge gains long-term bonds. Holders of five-year bonds did better but not in that sector caused the entire S&P 500 to rise by 32% well. During the subsequent disinflation, both categories of and 18% respectively, while the rest of the stocks in the S&P bonds soared. Thus, if you expect inflation rates to rise, don’t buy had mediocre performance. nominal bonds! Or, if you do, keep the maturity as short as you can.

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LONG-TERM NOMINAL BONDS BECOME “CERTIFICATES NOMINAL BONDS AND TIPS HAVE PROFOUNDLY OF CONFISCATION” IN INFLATIONARY EPISODES, THEN DIFFERENT INFLATION SENSITIVITIES RECOVER IN DISINFLATION Exhibit 5: In ation sensitivity and real-interest-rate sensitivity Exhibit 4: Real total return (cumulative index) on long-term and of nominal bonds and TIPS intermediate-term US Treasury bonds vs. in‹ation rates Ination sensitivity December 1949–December 1999 18 Real (ination-adjusted) value of $1.00 Annual ination rate (%) 16 invested on 12/31/1949 14 $4.00 16% 12 Nominal $3.50 14% 10 bonds 12% 8 $3.00 Long-only unleveraged portfolios 10% 6 of nominal bonds and TIPS $2.50 8% 4 Cash 2 $2.00 6% TIPS 0 4% $1.50 -2 2% 0 2468101214161820 $1.00 0% Real-interest-rate sensitivity $.50 -2% Source: Siegel and Waring (2004). $0 -4% Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec ’49 ’54 ’59 ’64 ’69 ’74 ’79 ’84 ’89 ’94 ’99 Treasury-Federal Reserve accord ended the last era (before the Long bond: Real total return index (lhs) present one) of artificially low short-term rates, to 2007, when Intermediate bond: Real total return index (lhs) the current ultra-low-rate era began, the correlation of Treasury Ination (12-month rolling rate) (rhs) bill returns and inflation rates was a sky-high 0.72: an excellent Source: Franklin Templeton Capital Markets Insights Group, Morningstar, Ibbotson hedge. The real return on Treasury bills was a compound annual Associates, Author’s Calculations. August 2019. 1.3% over this period—which included a long spell of negative real rates in the 1970s. As we saw in Exhibit 5, cash and various Inflation-indexed bonds maturities of TIPS form a continuum of inflation hedges, all While TIPS and nominal Treasury bonds are superficially similar having a theoretical inflation sensitivity of zero. (they have the same issuer, the same credit risk, and so forth), they are diametric opposites in terms of their inflation The reality in today’s brave new world of profoundly manipulated sensitivity. Exhibit 5, from Siegel and Waring (2004), shows short-term rates is different. Over 2009 to 2015, real rates this relationship. Nominal bonds are seen to have high inflation averaged negative 1.6%, and are still close to zero. The era of durations (that is, they react poorly to inflation shocks)— artificially low rates could continue for a long time. the longer the term of the bond, the larger the inflation duration. Manipulated rates are not new. However, a nearly worldwide TIPS and cash, however, have a zero inflation duration. Their policy of keeping short-term interest rates well below the inflation price does not react to inflation surprises. rate is unprecedented in a non-crisis environment (or else mone- TIPS are, then, a near perfect inflation hedge.14 The only risk, tary authorities think they’re always in a crisis). Thus, it has other than whatever sovereign or credit risk exists in the bond, become risky to hedge inflation using cash, despite a long history comes from unanticipated fluctuations in the real rate. The down- suggesting that it is a reasonable strategy. side of investing in TIPS and other inflation-indexed products is Real estate their low yield: recently the 10-year US Treasury TIPS closed at a Real estate, in the sense of private real estate equity—being a record low yield of 0.02%. Typically yields are higher than that partner in the ownership of buildings—has traditionally and but not, in the recent past, much over 1%—a meager yield by correctly been considered a good inflation hedge. The reason is any standard. Still, if inflation hedging is the goal and not return largely mechanical: rents, and thus selling prices (the capitalized enhancement, TIPS are the asset you want. value of future rents) tend to rise with nominal incomes.

Cash But real estate is far from perfect as an inflation hedge. We need Interest-bearing “cash” has been a classic inflation hedge, only look at the housing bubble and its bursting to see that real closely tracking inflation over most periods. From 1952, when the estate can sometimes earn sharply negative returns while

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inflation rates are positive. The TIAA Real Estate Account, a Thus, while real estate is a much better inflation hedge over the well-regarded and representative portfolio of office, apartment, short run than equities (responding positively rather than and other buildings in the US, fell 14.2% in 2008 and then negatively to the inflation level), there is still the stock-like effect 27.6% in 2009, wiping out years of prior gains—but it has recov- of declining inflation rates being slightly more positive for real ered and moved to new highs, as have most US properties and returns on real estate than rising ones. property funds.15 Real estate investment trusts During the Great Inflation of the 1970s and early 1980s, real Many investors try to gain exposure to real estate through public estate performed extremely well, outpacing inflation and equities, particularly real estate investment trusts (REITs), but providing lavish returns to investors who had leveraged their posi- also other real estate-related stocks. This has not proven to be a tions at the low interest rates that had prevailed before inflation good strategy for hedging against inflation, because REITs tend to rocketed upward. Most of the academic studies of real estate as act more like stocks and less like the underlying real estate.16 an inflation hedge cover this critical period. Larsen and Macqueen (1995) write: Commodities Commodity prices should also be mechanically related to overall Tests by Fama and Schwert (1977) find that real estate hedges inflation rates, at least in the short to intermediate run, inflation; however, they use changes in the Home Purchase Price because they are part of the market basket that is used to calcu- index as a proxy for real estate returns. [Thus their result] is based on a narrow category of real estate…Tests by Hartzell, late the consumer (or producer) price level. But commodity Hekman, and Miles (1987) also find that real estate is a good prices are extremely volatile, and cannot be used to hedge inflation hedge… against inflation shocks except as a small part of a much broader portfolio strategy. Yet these celebrated academics did not perform the relatively simple task of separating the inflation-hedging property of The analyst and wealth manager, Barry Ritholtz, likes looking at real estate into the part related to levels of inflation and the part the big picture; so do we, so we reproduce in Exhibit 7 (on related to the direction of change. In a little-known article the next page) his chart showing the price of a commodity basket in The Actuary, Pierandri and Fitzgerald (1989), drawing on work from 1749 (!) almost to the present. (While it’s fun to look at by Equitable Real Estate, observe: such long-term data, another reason for using this chart is that it’s the only one we could obtain that went back before the Using as a model a Class A downtown office building in a major beginning of the Great Inflation.17) market, 10-year rates of return were calculated under three inflation scenarios including disinflation (3.1%), constant (6.0%), Focus on the period starting in 1951. Inflation from 1951 to and hyperinflation (9.4%). As expected, hyperinflation created 1968 was moderate, much that like of today—although, by the highest nominal rate of return at 15.4%, but disinflation 1968, it was accelerating enough to be a worry (the 1968 rate actually [produced the highest real return], 10.8%, almost was 4.2%). Over this period, the CRB commodity index shown doubling the hyperinflation [real] return of 6.0%. The authors summarize the results of the Equitable study in Exhibit 6: in Exhibit 7 actually declined. Then, as inflation rocketed upward at the end of the 1960s and through the 1970s, commodities LIKE STOCKS, REAL ESTATE PERFORMS BEST IN soared, more than tripling in price between 1968 and 1980 PERIODS OF DISINFLATION (more than the increase in the CPI). Exhibit 6: Historical rates of return on an office building under three inflation environments The great disinflation of 1980–1999 caused commodity prices to Inflation environment Real rate Nominal rate drop almost in half; remember that inflation rates were still positive during this period, although much lower than before. Disinflation (3.1%) 10.8% 13.9% Since 1999, there has been a great deal of volatility, related to Constant (6.0%) 8.3% 14.3% the Global Financial Crisis, various emerging-market booms

Hyperinflation (9.4%) 6.0% 15.4% and busts, and changes in supply and demand in the energy Source: Pierandri and Fitzgerald (1989). complex (which is the largest component of most commodity indices), but the overall trend has been upward.

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COMMODITY PRICES GENERALLY TRACK INFLATION, BUT WITH A LOT OF VOLATILITY Exhibit 7: Commodity prices (CRB index) 1749–2011

500 2008 462.74 450 400 1980 2006 350 330.03 354.20

300

250 200 1781 1864 1951 1999 136.30 1815 131.42 1920 134.86 187.16 150 103.84 112.03 1792 1933 Last: 100 30.26 1843 1897 29.30 1968 Aug 2011 32.32 26.71 342.57 50 97.90 0 1749 1759 1769 1779 1789 1799 1809 1819 1829 1839 1849 1859 1869 1879 1889 1899 1909 1919 1929 1939 1949 1959 1969 1979 1989 1999 2009 Source: Bianco Research L.L.C., 2012

It is also important to note that commodity prices, overall, have Commodities: Conclusion risen less than consumer prices. That is, the very long-term Commodity investing is extremely complex. Taking into account: trend of real commodity prices is down. The reason is greater • Commodities’ positive correlation with inflation efficiency in using resources: we are doing more with less. • The higher return of futures vs. spot prices That is, roughly, a good definition of economic growth, of which we’ve experienced a lot since 1749!18 • Commodity price volatility

Commodity futures • Periods of negative correlation Interestingly, portfolios of commodity futures, collateralized with • The very long-term downtrend of real (but not nominal) interest-bearing cash, have significantly outperformed the commodity prices “spot” prices of commodities shown in Exhibit 7 (see the influen- We conclude that a small allocation to commodities for the tial paper by Gorton and Rouwenhorst [2006].) In Exhibit 8, purpose of hedging inflation risk is appropriate, but that these authors demonstrate that, alone among the major asset large allocations would introduce unacceptable levels of total classes (they did not consider real estate), commodity futures risk into the portfolio. Commodity futures are a dish best are positively correlated with both the anticipated and unantici- served sparingly.19 pated (shock) components of inflation:

Liabilities and asset-liability portfolios COMMODITY FUTURES WERE POSITIVELY CORRELATED WITH INFLATION OVER 1959–2004 These days, most institutional and individual investors’ liabilities Exhibit 8: Quarterly correlation of assets with components are real: retirement savings, endowments, foundations, and of inflation DB pension plans with a COLA fall into this category. These asset July 1959–December 2004 pools must be protected against the inflation ninja to the Inflation environment Inflation Change Unexpected greatest extent that can be achieved while pursuing the investor’s in expected inflation other goals. inflation

Stocks -0.19 -0.10 -0.23 A few categories of investors have nominal liabilities. These include DB pension plans without a COLA, insurance reserves for Bonds -0.22 -0.51 -0.35 certain types of policies and contracts, and corporations and Commodity Futures 0.14 0.22 0.25 governments that have issued nominal debt. Such investors do Source: Gorton and Rouwenhorst (2006).

11 Protecting Portfolios November 2019 Against Inflation

not need to worry about inflation as much, because inflation Like the inflation rate, real output (GDP) fluctuates, sometimes is their friend (they can pay off their nominal debts in cheaper dramatically. While an analysis of GDP is mostly beyond the dollars). This paper focuses on investors with real liabilities. scope of this paper, we note that these fluctuations, too, have been wild, and not just in the distant past. The Great Revisiting the Very Simple Macro Model Recession involved an economic contraction of about 6% of To understand what inflation shocks may be forthcoming in GDP, the largest or second largest decline (depending on the future, it helps to have a mental macroeconomic model of how you measure) since the Great Depression, when economic the economy. In “Real Interest Rate Shocks and Portfolio activity contracted by a heart-stopping 25% in four years. Strategy,” we set forth a Very Simple Macro Model (VSMM), wholly non-mathematical and thus useful in the current context.20 Explaining inflation with the Very Simple Macro Model Reduced to its elements, the VSMM says that macroeconomic The tension between these two forces, the real business cycle outcomes reflect the tension between the real business and the effects of government intervention, explains a good deal cycle, on one hand, and government intervention in the economy, of what we need to know about both past and future inflation. on the other. Real business cycle 1. Real business cycle. If monetary policy were completely The real business cycle hypothesis predicts high inflation when neutral, there would still be business cycles because informa- businesses are ramping up spending and investment, because tion about the future is always incomplete. So, businesses they are outbidding each other for resources, such as labor, that overreact to shocks, for example, an unexpected increase in are inelastic in terms of their availability (supply). We should have demand. They respond to this by ramping up supply; this disinflation or outright deflation in the bust part of the cycle. is the boom part of the cycle. But businesses usually build Moreover, under totally neutral monetary conditions, in the long capacity beyond the equilibrium point, and when the excess run prices should fall gradually due to economic growth. capacity proves to be unjustified, you get the bust phase. This occurs because it takes fewer resources to produce the The bust phase ends when the slack in demand causes input same amount of goods and services; that’s what economic prices to be so low that investment becomes highly rewarding, growth is. We saw this in 1870–1914, the period of the Second and you get a new boom. Industrial Revolution, when the gold standard produced neutral monetary conditions and, both in the US and elsewhere, 2. Government responsibility. But monetary and fiscal policy are economic growth was robust. Prices ended the period lower than not neutral; the government has taken on the responsibility they started.21 of “managing” the economy by adopting a stimulative stance when times are bad and a restrictive stance when they’re It sounds like the second story contradicts the first, but this good. (We’d caution that governments are notoriously bad at contrast just reflects the fact that, in the real business cycle, this and are usually behind the curve, often exacerbating short-term and long-term inflation have different causes. swings instead of dampening them.) Governments pursue the Government intervention: Monetary policy. goals of (1) full or mostly full employment, and (2) stable Milton Friedman famously said, in 1968, that “inflation is always prices or at least low inflation rates. and everywhere a monetary phenomenon.”22 This was true But governments rarely succeed at such a delicate balancing when he said it, because the Federal Reserve had almost total act. As we saw in Exhibit 1, inflation rates have only been control over the money supply, we were on a quasi-gold stable for about 25 years. Before that, there were wild swings (Bretton Woods) monetary standard, and monetary and fiscal in inflation. We should not become complacent and expect policies had to be co-managed or else the currency would fluc- the current placid condition to continue indefinitely. The tuate beyond acceptable limits in the context of the Bretton massive amount of government debt in the US and elsewhere, Woods agreement. So, the inflation of Friedman’s time was and the planned increase in this indebtedness in future primarily due to an expansion in the money supply at a rate faster years, should give pause to any expectation that inflation will than the expansion in the real economy. remain low. And, in 1971, the dollar-gold link was broken (for the last time; it was an evolutionary process that started in 1933),

12 Protecting Portfolios November 2019 Against Inflation

inflation began to roar, and the dollar crashed against other major to forecast inflation if we’re going to construct portfolios that are currencies. In the US, consumer prices doubled in the 1970s, defended against future inflation shocks! a feat unprecedented in peacetime. This represented the climax Government intervention: Fiscal policy of the Great Inflation that began in the immediate post-World Fiscal policy also affects the price level. A modern take on mone- War II period and that decimated the real value of bondholders’ tarism, called the Fiscal Theory of the Price Level (FTPL), is and savers’ balances. gaining favor. It says that government bond investors expect the But the Great Inflation was not to continue forever or slip into government to run primary surpluses (revenues minus expenses hyperinflation. The monetarist interventions of Fed chair other than debt service) sufficient to support the interest and Paul Volcker, who was appointed by President Carter on August principal repayment promises made in the bond indenture. Let’s 6, 1979, eventually brought inflation under control, and it call the present value of these expected primary surpluses the has remained under control since about the end of 1982. The government’s “market capitalization.” Bonds are thus a kind of compound annual inflation rate from December 31, 1982 share of stock in the government. to June 30, 2019 has been a modest 2.68%, and year-to-year The price level is then determined by the number of bonds issued fluctuations have also been mild. Nobody who lived through the against the market cap of the government. If the government 1970s and 1980–1982 foresaw this. increases the size of its debt, the prices of the bonds will fall What happened? There was much debate about the causes of relative to consumer goods and services, and you’ll have a higher inflation in the 1970s, which were thought to include demand- inflation rate.23 pull (too much demand and not enough supply), cost-push Thus, the traditional monetarist view that fiscal policy only (scarce resources), corporate greed, labor union greed and inflexi- affects inflation to the extent that is causes more money to be bility, and other chimeras. The fact that inflation rates came “printed” is not quite right. If fiscal policy forces more government way down when Volcker applied monetary remedies in the early bonds to be issued and sold to the public, without any 1980s put an end to this debate: if the fix was monetary, the additional backing in the form of expected future government problem had also been monetary. Having learned its lesson, the surpluses, inflation will increase. In other words,government Fed never tried its unorthodox 1970s hyper-expansionary mone- bonds are a form of money, with “money” being a continuum tary policies again. from currency to bank demand deposits to short-term Treasury The Global Financial Crisis and its mysterious aftermath bills to longer-term government bonds to, conceivably, shares Until it did. In an attempt to avoid having the Global Financial of the S&P 500, or pieces of your house (accessed through home Crisis cause another Great Depression instead of the Great equity lines of credit). The government no longer controls the Recession that occurred, governments around the world pursued money supply and we have to look elsewhere for clues to future monetary and fiscal policies that were expansionary in the inflation rates. extreme in the 2007–2009 period. Some of these policies Inflation and the VSMM: Summary continued almost up to the present. Yet inflation did not accel- Exhibit 9 on the next page summarizes the foregoing discussion. erate, and has remained around 2% per year in the entire period Influences on long-term inflation are shown in the top part of the since then, confounding traditional monetarists who expected a diagram, and include some items (the cost disease and the resurgence of inflation, possibly a drastic one. nonrenewable resource problem) that we haven’t discussed; we’ll The lack of inflation in such a stimulative environment remains summarize them very briefly. Influences on short-term inflation something of a mystery. Some observers credit the position are in the bottom part and are separated into real business cycle of the US dollar as the world’s reserve currency. Some believe and governmental categories. that the money supply can no longer be estimated using the Upward pointing or slanting arrows represent rising inflation conventional measures of M1, M2, and so forth because private rates; downward pointing or slanting arrows, declining inflation issuers of “quasi-money,” such as banks, money market funds, rates. The exhibit is color coded so that inflationary influences credit grantors, and hedge funds, not the Fed, now issue what are in orange (suggesting a negative outcome) and disinflationary really counts as “money.” Further research is needed and we do influences are in green.24 not know the answer—but it would help to have a clue as to how

13 Protecting Portfolios November 2019 Against Inflation

REAL ECONOMIC GROWTH DAMPENS LONG-TERM Exhibit 10 shows the projected increase in the debt/GDP ratio, INFLATION, BUT MANY OTHER INFLUENCES AFFECT which assumes the increased spending we just discussed, INFLATION IN THE SHORT TERM and normal rates of productivity growth. If productivity grows Exhibit 9: Schematic diagram of in uences on in ation significantly faster, the problem will not be nearly as severe, because the debt/GDP ratio is a leveraged quantity. So, policy- Baumol cost disease makers should focus on enhancing productivity. Long-term trend of real economic growthHotelling principle (nonrenewable resources)

Long-term AS BABY BOOMERS RETIRE, US GOVERNMENT DEBT/GDP RATIO IS PROJECTED TO GROW BEYOND ITS FORMER WARTIME HIGH Exhibit 10: Debt held by the public under projections from the 2018 Financial Report, the Congressional Budget Of ce (CBO), and Government Accountability Of ce (GAO) Bust Boom

Easing Percentage of gross domestic product Austerity Stimulus Tightening Short-term 250 Actual Projected 200 Monetary Fiscal REAL BUSINESS CYCLE GOVERNMENT 150 Source: Franklin Templeton, for illustrative purposes only. 100 Historical high = 106% in 1946 50 The future of inflation Historical average = 46% since 1946 We don’t know how to forecast future consumer prices (that is, 0 inflation) or the prices of any other asset; if we did, we’d be 2000 2010 2020 2030 2040 2048 Fiscal year billionaires. However, we can render a few informed guesses CBO’s June 2018 extended balance GAO’s baseline simulation about how current and projected future economic conditions in GAO’s alternative simulation 2018 Financial Report the United States (and, by inference, in other countries with Source: GAO, Congressional Budget Ofce, and 2018 Financial Report. April 2019. similar fiscal dilemmas) might translate to inflation shocks.

In the work of Sexauer and Van Ark (2010), the key variables in Now, what does all this have to do with inflation? As we determining future government debt/GDP ratios are: (1) produc- suggested earlier, inflation is a hidden or ninja tax, a way of tivity growth, and (2) the growth rateREAL of government ECONOMIC spending GROWTH DAMPENSpaying LONG-TERM off debts in cheaper dollars so that explicit taxes (the kind INFLATION, BUT MANY OTHER INFLUENCES AFFECT relative to GDP.25 We can grow out way out of the debt problem, you pay by writing a check to the tax authority) can be kept INFLATION IN THE SHORT TERM within reason. Governments are powerfully motivated to create as Canada and Sweden have, if—andExhibit only 9:if—government Schematic diagram of in uences on in ation spending grows more slowly than productivity. The authors write: inflation—if they can—when they are deeply in debt. The last time the US government had a high debt/GDP ratio, in 1946 just As long as the economy grows beyond population and inflation Baumol cost disease Long-term trend of real economicafter World growth War II ended, cumulative inflation over the next growth, and some of the productivity-driven growth is Hotelling principle 35 years was five-to-one. It could happen again, although govern- used for debt reduction rather than spending increases, the (nonrewable resources)

combination of these policy principlesLong-term should cause the ment policies seem to have less influence on inflation rates than debt-to-GDP ratio to fall. they once did, so it won’t repeat exactly.

So, there is a way to solve the debt problem. Unfortunately, But, there is another wrinkle we must consider. Governments increases in government spending beyond the growth rate of must be able to service their debt out of current revenue. productivity seem to be baked into the cake for quite a while. Once you start to borrow new principal just to pay interest on Bust Boom Easing Austerity

existing debt, you’reStimulus at the inflection point in Ernest Hemingway’s

Mostly the increases consist of entitlement spending for aging Tightening Short-term baby boomers, who are scheduled to receive large Social Security famous wisecrack about how a character in one of his novels and Medicare benefits. Eventually they’ll die and the country will went bankrupt: “Gradually and then suddenly.” Monetary Fiscal be younger and fiscally healthier, but that is in the far future, REAL BUSINESS CYCLE And, at GOVERNMENThigh levels of indebtedness, servicing the debt out of beyond the maturity date of all but the longest-term Treasury current income (and leaving something for the services that2000 2000 2000 2000 2000 2000 bonds and beyond the time horizon of most investors.

14 Protecting Portfolios November 2019 Against Inflation

government is supposed to provide) requires keeping interest International issues rates low, as shown in Exhibit 11. So, we can expect govern- Investors in one country (say, the US) may wish to hedge ments around the world to use whatever tools are at their disposal domestic inflation by buying securities in another country (say, to keep interest rates as low as possible, for as long as possible. Switzerland) believed to pose less of an inflation risk. If inflation accelerates and governments can keep interest The return from such a strategy often comes from currency rates low, that means negative real rates on government debt— appreciation (of the low-inflation currency relative to the high- something we are already seeing in many markets including, as of inflation one). mid-2019, the United States. Non-US investors who want to hedge their own domestic inflation We seriously doubt that governments can keep interest rates risk can consider a similar strategy. Investors in perennially as low as they are now, in the face of potentially higher inflation, high-inflation countries have tried to keep most of their assets just because it is in their interest. They have had to pay high offshore. The US dollar has been the favored currency for rates before, in the 1970s and early 1980s. But if rates and debt such investors, although the US no longer has the world’s lowest levels are high, governments will face unprecedented financial inflation rates; those are in Europe and Japan. distress, a scenario we do not look forward to. Strategies for protecting against inflation shocks through interna- The bottom line is that inflation could be surprisingly high in the tional investing can be complex and, other than the brief next generation, and nominal interest rates lower than we’d comments above, beyond the scope of this paper. In a recent and expect by studying history. This combination could produce nega- thoughtful article, Rödel (2014) writes: tive real rates. It’s a dismal scenario for investors who are concentrated in nominal fixed income. Protecting a portfolio from International equities hedge against inflation levels and inflation inflation shocks, using the strategies discussed in this article, changes more effectively than do domestic equities. The protec- tion is stronger for country-specific inflation shocks and for is imperative if your liabilities or investment goals are in any way weak domestic currencies. International equities thus protect influenced by inflation. investors who need it the most, but remain an insufficient hedge for investors in the most monetarily stable countries. INDEBTED GOVERNMENTS HAVE A POWERFUL INCENTIVE Thus, US investors may not benefit as much from international TO KEEP NOMINAL INTEREST RATES, AND THUS INFLATION, LOW—IF THEY CAN investing, in terms of its inflation hedging properties, as investors Exhibit 11: Projected net interest spending in dollars and as a domiciled in places that have a lot of inflation risk.26 percentage of total federal spending Dollars in trillions Percentage Conclusion 90 45% Inflation is like a thief in the night. Unseen and, in normal times, 80 40% barely felt, it destroys the real value of portfolios as it increases 70 35% the burden of liabilities. Small amounts of inflation, compounded 60 30% over long periods of time, become big ones. And the fiscal 50 25% position of leading countries, including the US, suggests that 40 20% inflation rates will not remain low forever. 30 15% 20 10% To protect a portfolio against inflation, investors can increase 10 5% their weightings of inflation-indexed bonds and real assets. 0 0% 2018 2028 2038 2048 2058 2068 2078 2088 2092 Cash is not the reliable inflation hedge it was once thought to be, and equities provide a very volatile and unreliable hedge, Nominal dollars, trillions As a percentage of total federal spending although in the very long run equities should rise with consumer Net interest spending is projected to exceed spending on: and producer prices (and then some). While inflation does Nondefense discretionary Medicare spending spending in 2024 in 2042 not seem like a threat to portfolio values at this time, that is when investors should be most vigilant. Beware the ninja. Defense discretionary Social Security spending spending in 2025 in 2046 2040 2040 2040 2040 2040 2040 2040 2040 2040 Source: GAO and GAO analysis of Congressional Budget Of ce Data. April 2019.

15 Protecting Portfolios November 2019 Against Inflation

References

Attié, Alexander P., and Shaun K. Roache. Friedman, Milton. 1963. Inflation: Causes Lintner, John. 1973. “Inflation and 2009. “Inflation Hedging for Long-Term and Consequences, Council for Economic Common Stock Prices in a Cyclical Investors.” IMF Working Paper No. 09/90, Education, Bombay (Mumbai), India: Asia Context.” National Bureau of Economic https://www.imf.org/external/pubs/ft/ Publishing House. Research 53rd Annual Report, New York wp/2009/wp0990.pdf Friedman, Milton. 1970. Counter- Marshall, David A. 1992. “Inflation and Barnes, Michelle L., Zvi Bodie, Robert K. Revolution in Monetary Theory. Wincott Asset Returns in a Monetary Economy.” Triest, and J. Christina Wang. “A TIPS Memorial Lecture, London: Institute of Journal of Finance (September). Scorecard: Are They Accomplishing Their Economic Affairs, Occasional Paper 33, Pierandri, Harry D., and Thomas J. Objectives?” Financial Analysts Journal, page 24, https://miltonfriedman.hoover. Fitzgerald. 1989. “Equity Real Estate.” vol. 66, no. 5 (September/October), org/friedman_images/Collections/ The Actuary, Volume 23, No. 6 (June) pp. 68–84. 2016c21/IEA_1970.pdf. Rödel, Maximilian. 2014, “Inflation Barro, Robert. 1974. “Are Government Gorton, Gary, and K. Geert Rouwenhorst. Hedging with International Equities.” Bonds Net Wealth?” Journal of Political 2005. “Facts and Fantasies about Journal of Portfolio Management 40, no. 2 Economy, vol. 82, no. 6, pp. 1095–1117. Commodity Futures.” Financial Analysts (Winter), pp. 41–53. Journal, Vol. 62, no. 2 (March/April), Baumol, William J., and William G. pp. 47–68. Sexauer, Stephen C., and Bart Van Ark. Bowen. 1966. Performing Arts, The 2010. “Escaping the Sovereign-Debt Economic Dilemma: a study of problems Grant, James. 2019. “The Fed Could Crisis: Productivity-Driven Growth and common to theater, opera, music, and Use a Golden Rule.” Wall Street Journal Moderate Spending May Offer a Way dance. Cambridge, Mass.: M.I.T. Press. (July 12), https://www.wsj.com/articles/ Out.” Executive Action Series, Conference the-fed-could-use-a-golden-rule- Bodie, Zvi. 1976. “Common Stocks as a Board, New York. 11562885485 (gated) Hedge against Inflation.”Journal of Siegel, Laurence B. 2019. Fewer, Richer, Finance, vol. 31 (May), pp. 459–470. Hartzell, David, John S. Hekman, and Greener: Prospects for Humanity in Mike E. Miles. 1987. “Real Estate Returns Chen, Peng, and Matt Terrien. 2001. an Age of Abundance. Hoboken, NJ: and Inflation.”AREUEA Journal, vol. 15 “TIPS as an Asset Class.” Journal of John Wiley & Sons. (Spring), pp. 617–637. Investing, vol. 10, no. 2 (Summer), Siegel, Laurence B., and M. Barton pp. 73–81. Hotelling, Harold. 1931. “The Economics Waring. 2004. “TIPS, the Dual Duration, of Exhaustible Resources.” Journal of Cochrane, John H. 2019. The Fiscal and the Pension Plan.” Financial Analysts Political Economy, vol. 39, no. 2, pp. Theory of the Price Level. Book draft, Journal, vol. 60, no. 5, pp. 52–64. 137–175. https://faculty.chicagobooth.edu/john. Strongin, Steve, and Melanie Petsch. cochrane/research/papers/fiscal_theory_ Kalecki, Michal. 1943. “Political Aspects 1997. “Protecting a Portfolio Against book.pdf of Full Employment.” Political Quarterly, Inflation Risk.”Investment Policy, vol. 1, vol. 14 (October-December), pp. 322–331, Fama, Eugene F., and G. William Schwert. no. 1, pp. 63-82. https://delong.typepad.com/kalecki43.pdf 1977. “Asset Returns and Inflation.” Tollette, Wylie, and Gene Podkaminer. Journal of Financial Economics, vol. 5 Larsen, Alan B. and Grant R. Mcqueen. 2019. “‘What if…?’ Shocks to inflation.” (November), pp. 115–146. 1995. “REITs, real estate, and inflation: San Mateo, CA: Franklin Templeton, Lessons from the gold market.” Journal of corporate communication. Real Estate Finance and Economics, Volume 10, Issue 3 (May), pp 285–297.

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Contributors Gene Podkaminer is a senior vice president and head of multi-asset research strategies for Franklin Templeton Multi-Asset Solutions. In this role he directs research activities across markets and asset classes, strategic and tactical asset allocation, manager due diligence and selection, including quantitative and fundamental approaches. Mr. Podkaminer chairs the Investment Strategy Research Committee which informs asset allocation strategy across the multi-asset solution organization.

Prior to joining Franklin Templeton in 2018, Mr. Podkaminer worked with Callan in the Capital Markets Gene Podkaminer, CFA Research group where he was responsible for assisting clients with their strategic investment Head of Multi-Asset Research Strategies planning, conducting asset allocation studies, developing optimal investment manager structures, and Franklin Templeton providing custom research on a variety of investment topics. Prior to Callan, Mr. Podkaminer Multi-Asset Solutions spent nearly a decade with Barclays Global Investors. As a Senior Strategist in the Client Advisory Group he advised some of the world’s largest and most sophisticated pension plans, non-profits, and sovereign wealth funds in the areas of strategic asset allocation, liability driven investing, manager structure optimization, and risk budgeting. As chief strategist of Barclays’ CIO-outsourcing platform Mr. Podkaminer executed CIO-level functions for corporate pension plans and endowments.

Mr. Podkaminer received a BA in Economics from the University of San Francisco and an MBA from Yale University. He earned the right to use the Chartered Financial Analyst designation and is a member of the CFA Society of San Francisco and CFA Institute, where he consults on curric- ulum development. He is a frequent speaker on investment related topics and has been featured in numerous publications; in 2014 he was named CIO Magazine’s “Consultant of the Year.” “Risk Factors as Building Blocks for Portfolio Diversification: The Chemistry of Asset Allocation,” was published by the CFA Institute, “The Education of Beta: Can Alternative Indices Make Your Portfolio Smarter,” was featured in The Journal of Investing, and “Smart Beta is the Gateway Drug to Risk Factor Investing” appears in The Journal of Portfolio Management.

Wylie Tollette is executive vice president and head of client investment solutions for Franklin Templeton Multi-Asset Solutions. In this role, his key responsibilities include oversight of client invest- ment solution development for our multi-asset platform. Mr. Tollette and his team partner closely with the company’s global distribution groups on all Multi-Asset Solutions opportunities across a broad range of clients.

Prior to rejoining Franklin Templeton, Mr. Tollette served as chief operating investment officer at Wylie Tollette, CFA, CPA CalPERS, the largest defined benefit public pension fund in the U.S. There, he helped to lead initia- Head of Client Investment Solutions tives focused on enhancing the portfolio and investment decision making process, engaged the Franklin Templeton CalPERS Board and various constituents, and helped to redesign the asset allocation and investment Multi-Asset Solutions strategy committee. Mr. Tollette was also responsible for the investment performance and risk analytics, investment policy, investment manager engagement, operations, compliance, and business planning areas.

Prior to his time at CalPERS, Mr. Tollette worked at Franklin Templeton for almost 20 years, including as the head of the Performance Analytics and Investment Risk team, which was responsible for collaboratively defining, measuring and managing investment risk and performance across all Franklin Templeton products and clients.

17 Protecting Portfolios November 2019 Against Inflation

Wylie Tollette Mr. Tollette received a BS from the University of California, Davis and received his Master of Science continued in Finance from the University of London. He is a Chartered Financial Analyst (CFA) charterholder and is a member of the CFA Association of Sacramento and San Francisco. He has served on a number of the CFA Institute’s committees, including the GIPS Technical committee. He also holds a CPA designation and is a member of the American Institute of Certified Public Accountants.

Laurence B. Siegel is the Gary P. Brinson Director of Research at the CFA Institute Research Foundation and an independent consultant. His book, Fewer, Richer, Greener: Prospects for Humanity in an Age of Abundance, (www.fewerrichergreener.com), was published by John Wiley & Sons in December 2019.

From 1994 to 2009 he was Director of Research in the investment division of the Ford Foundation. Prior to that, he was one of the founding employees of Ibbotson Associates (now part of Morningstar). Laurence Siegel Gary P. Brinson Director Mr. Siegel is the author of more than 200 articles on investing and related topics. He has won many of Research writing awards including the Graham and Dodd Award, the Bernstein Fabozzi/Jacobs Levy Award, and CFA Institute Research the EDHEC/Robeco Award. His work may be accessed at www.larrysiegel.org. Foundation Larry is an editorial advisory board member of The Journal of Portfolio Management and The Journal of Investing, and a board member of the Q Group (Institute for Quantitative Research in Investing) and the American Business History Center. He received his BA (1975) from the University of Chicago and his MBA (1977) from the same university’s Booth School of Business. He works and lives in Wilmette, Illinois and Del Mar, California and may be reached at [email protected].

Endnotes 1. The authors thank Stephen Sexauer, CIO of the San Diego County Employees Retirement Association (SDCERA), for the Very Simple Macro Model (his idea, our name). 2. In the post-World War II period, that is the highest rate for any full year (1979). The highest monthly rate was 1.81%, which annualizes to 24% (August 1973). 3. Tollette, Wylie, and Gene Podkaminer (2019). 4. Friedman (1970). 5. This statement ignores the possibility of the government selling assets it already owns; this can only be done once (for a given asset), and presumably the asset was acquired through past taxation, so that means of raising revenue isn’t really distinct from the others. In addition, some governments generate their own real economic resources by operating for-profit businesses, but that, again, is a side issue, limited to a few countries, and does not affect our story. 6. This principle is related to the notion of “Ricardian equivalence,” first set forth by the 19th century British economist David Ricardo and formalized by Robert Barro 150 years later (Barro 1974). Ricardian equivalence says that the choice of whether to finance government expenditures through current taxes or debt (future taxes) makes no difference in economic output because taxpayers, observing the debt issuance, know they will be required to pay off the debt through deferred taxation and adjust their consumption accordingly. 7. The term is of unknown origin and goes back to the Great Depression. See, for example, Kalecki [1943]. 8. A George Mason University (Fairfax, VA) online course explains in greater detail: “The most famous speech in American political history was delivered by William Jennings Bryan on July 9, 1896, at the Democratic National Convention in Chicago. The issue was whether to endorse the free coinage of silver at a ratio of silver to gold of 16 to 1. (This inflationary measure would have increased the amount of money in circulation and aided cash-poor and debt-burdened farmers.)” http://historymatters.gmu.edu/d/5354/ 9. Grant (2019). 10. Not by 1%, that is, from an annual rate of 2.00% to 2.02%, but one percentage point, that is, from an annual rate of 2.00% to 3.00%. It pays to be precise. 11. Bodie (1976). To support this statement, Bodie says that a good review of the literature on this question is in Lintner (1973). 12. Bodie, op. cit. My italics. We leave out the regression results because they are period-specific and very old, but the negative relation is dramatic and statistically significant. 13. David Marshall (1992) of Northwestern University writes, “The tendency of equity returns to covary negatively with inflation has been extensively documented using a variety of data sets.” He then lists eight studies, including three by the Nobel Prize winner Eugene Fama with and without co-authors. However, all of these studies cover roughly the same time period, so it’s not surprising that they reach similar conclusions. 14. See Chen and Terrien (2001), Siegel and Waring (2004), and Barnes et al. (2010). 15. Source: TIAA Real Estate Account FAQ, August 2019 https://www.tiaa.org/public/pdf/performance/REA_FAQ.pdf 16. There is an ongoing debate over whether the divergence between the underlying asset (real estate) and the leveraged financial claim (REITs) is due to the fact of securitization and the difference in ownership structure, on the one hand, or to a lack of inflation hedge properties in the value of the underlying real estate that is masked by appraisal-based pricing. We are not able to resolve that debate here.

18 Protecting Portfolios November 2019 Against Inflation

17. Except for the Producer Price Index for All Commodities, available from the Federal Reserve Bank of St. Louis (FRED), which goes back to 1913 but has a different composition and weighting scheme and a very different return pattern from the CRB. 18. Siegel (2019), figure 18.1, drawing on data from the Federal Reserve Bank of St. Louis. 19. Gold, often considered the prototype commodity, has over the long run had a return pattern similar to that of broad commodity indices and may be considered an inflation hedge, but is undiversified, has storage costs, and (unlike cash-collateralized commodity futures) provides no income, so it is not a feasible investment for most institutional portfolios. 20. Originally described by Stephen C. Sexauer, CIO of the San Diego County Employees Retirement Association, in a personal communication. 21. The low point for consumer prices was actually 1899, not 1914, but mild inflation between 1899 and 1914 did not bring the price level back to the 1870 starting point. 22. Friedman (1963). 23. For a very thorough explanation, see Cochrane (2019). A work in progress by one of us (Siegel), with Thomas Coleman and Bryan Oliver, will exposit these concepts in terms that are familiar to investment professionals. 24. The Baumol cost disease is the tendency of goods and services that are produced the old-fashioned way (such as violin playing) to rise in price, relative to consumer prices in general, because other goods and services are becoming cheaper due to increased efficiency while these are not. It’s hard to increase the efficiency of a violin performance delivered in person. See Baumol and Bowen (1966). The Hotelling principle (sometimes “Hotelling’s Rule”) states that nonrenewable resources will rise in price, again relative to all goods and services, at a differential rate equal to the riskless rate of interest. These are, of course, observations about relative, not absolute, prices, but if you’re budgeting for a college education (a Baumol good) or want to buy land (a Hotelling resource), you might find these differential inflation expectations relevant. See Hotelling (1931). 25. Sexauer and Van Ark (2010). 26. See Rödel (2014).

WHAT ARE THE RISKS? All investments involve risks, including possible loss of principal. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Investments in lower-rated bonds include higher risk of default and loss of principal. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political devel- opments. Investments in emerging markets involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size and lesser liquidity. Investments in fast-growing industries like the tech- nology sector (which historically has been volatile) could result in increased price fluctuation, especially over the short term, due to the rapid pace of product change and development and changes in government regulation of compa- nies emphasizing scientific or technological advancement. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in emerging markets involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size and lesser liquidity. Investments in fast-growing industries like the technology sector (which historically has been volatile) could result in increased price fluctuation, especially over the short term, due to the rapid pace of product change and development and changes in government regulation of companies emphasizing scientific or technological advancement or regulatory approval for new drugs and medical instruments. The risks associated with a private equity real estate strategy include, but are not limited to various risks inherent in the ownership of real estate property, such as fluctuations in lease occupancy rates and operating expenses, variations in rental schedules, which in turn may be adversely affected by general and local economic conditions, the supply and demand for real estate properties, zoning laws, rent control laws, real property taxes, the availability and costs of financing, environmental laws, and uninsured losses (generally from catastrophic events such as earthquakes, floods and wars). Real estate securities involve special risks, such as declines in the value of real estate and increased susceptibility to adverse economic or regulatory developments affecting the sector. Investments in REITs involve additional risks; since REITs typically are invested in a limited number of projects or in a particular market segment, they are more susceptible to adverse developments affecting a single project or market segment from more broadly diversified investments. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments; investments in emerging markets involve heightened risks related to the same factors. To the extent a strategy focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a strategy that invests in a wider variety of countries, regions, industries, sectors or investments.

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