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FT Portfolio Shocks WP V6.Indd 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 2 Protecting Portfolios November 2019 Against Inflation 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 3 Protecting Portfolios November 2019 Against Inflation 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.
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