With massive amounts of cash sloshing through the world’s economies, it’s only natural that investors should have nightmares about inflation. But by now, it’s too late do anything about it. People – let’s call them the markets – have already made gold a very expensive proposition.
So say researchers from AllianceBernstein. Inflation protection is a useful thing, they argue. But not all at once. It has to be part of a strategic asset allocation decision.
While stocks for the long run are supposed to be an inflation hedge, they don’t always work that way. There have been a number of 10-year rolling periods, reports John Ruff, AllianceBernstein’s director of research for inflation strategies, where a 60/40 bond portfolio has lost money in real terms.
“From a longer-term perspective, these inflationary shocks are not that unusual, and when they hit they can devastate traditional stock/bond portfolios,” Ruff explains. “Rising inflation is the one macro environment where stocks and bonds correlate to the downside. And the overwhelming conclusion is that you should not try to time the implementation of protection against the [inflation] environment. By the time the threat is imminent, protection will be too expensive and investors may hesitate to pull the trigger. So implementing inflation protection should be a strategic asset allocation decision – with tactical shifts made only at the margin.”
How do investors add an inflation hedge – apart from jumping into the gold pool? It’s difficult to determine because the only real data investors have is derived from the 1970s. AllianceBernstein therefore sought to construct a time series of inflation expectations and also of the performance of real assets over a much longer period.
Both are important to modeling an inflation-protected portfolio. Treasury Inflation Protected Securities have assumed a place in many institutional portfolios. How reliable are they?
“One interesting thing that we found was that TIPS may actually lose some of their inflation-hedging properties in high-rate environments,” says Ruff. “What seems to happen in high-rate environments is that changes in real yield start correlating with changes in the inflation expectations.” In addition, TIPS give up spread premia, compared to a diversified bond portfolio.
To construct an inflation-hedging portfolio, Ruff suggests three touchstones for analytical purposes: the inflation-sensitivity of an asset, the reliability of that sensitivity and return give-up as against an asset with a similar risk profile.
Inflation-sensitivity – or inflation beta – unsurprisingly jumps around. With TIPS, it’s because they are a step behind the market’s pricing of inflation (just as economists regularly are). They seemed to keep pace with nominal yields (with built-in inflation expectations), yet failed to reflect the real yields demanded in times of high inflation (in the reconstructed time series) suggests Ruff. Still, they rose 84% of the time during inflationary periods – significantly better than any other real asset class.
As for other inflation-sensitive assets – commodity stocks and commodity futures – they outperformed in the 1970s. “So you stop here and a lot of investors do. If you’re worried about inflation, then load up on precious metals and wait for the big one. Unfortunately, we don’t think it’s that simple,” Ruff says. In fact, precious metals futures rose only 49% of the time during periods of rising inflation.
“Just because certain assets act in certain ways on average doesn’t mean that they always do,” he notes. “It’s basically a coin toss: when they work, they work big but don’t put all of your eggs into one basket because these things can be down as often as they are up in an inflationary environment.”
Eggs are an instructive point here. Once they were widely traded as commodity futures. Now the futures contracts are defunct (along with those for potatoes, rye and wool).
Nevertheless, Ruff reports on simulations of “the combination of real assets that maximizes the volatility-adjusted return for a given level of inflation beta and inflation sensitivity. We see that for any given level of inflation beta, you could have picked up a huge amount of risk-adjusted returns by combining these assets into portfolios.”
The real assets? One-third real estate, one-third commodity stocks and one-third commodity futures. But that’s an idealized portrait.
Instead, investors have to look at what inflation-protected assets are available to them, before trying to define a portfolio says Vince Childers, a member of Ruff’s team at AllianceBernstein. They could consist solely in TIPS, either short or longer-dated, which might yield CPI plus 50 basis points. Or they could include commodity and real estate stocks and commodity futures (with TIPS as the collateral for the futures contracts), which might yield CPI plus 500 basis points.
“We think that investors should draw their protection from whatever combination of these kind of inflation-hedging vehicles fits with their risk profile,” he says. “Once the risk-appropriate tool set is available, we’ve passed the first hurdle in terms of building an inflation protection asset allocation. The next step is in answering the question of how much is to be allocated to inflation protection.”
And how is that question to be answered? “Not surprisingly to answer the question of how much inflation protection you should have is the old reliable question: it depends,” Childers says. Risk tolerance, pension funding status and demographics as well as the inflation beta of existing portfolio assets all play a part.
“The key takeaway,” he cautions, “is that there’s no one-size-fits-all solution when it comes to inflation protection. The type and amount of inflation protection can and should vary widely across investors.”