Inflation in the U.S. has accelerated from near zero in 2015 to 2.5% in 2018 (according to the Consumer Price Index or CPI), propelled by trade tensions, strong consumer spending, the tight labor market, and a boost in growth from tax reform and other fiscal stimulus. After so many years of low inflation, the rise in 2018 points to the possibility of an inflation surprise.
Such a surprise could be damaging because many investors may be too reliant on diversification achieved by investing in a portfolio of stocks and bonds, which is predicated on the historical negative correlation between the two asset classes. However, this diversification may not work as well going forward because correlation between stocks and bonds tends to rise when inflation is elevated. Therefore, we suggest investors consider real assets (inflation fighters) to make portfolio diversification more robust and hedge against the risk of higher inflation.
Will stocks and bonds deliver the same diversification at higher inflation rates?
The correlation between U.S. stocks and bonds has been low or negative when inflation has been low to moderate. Over the past couple of decades of low inflation, portfolios that were diversified across nominal bonds and stocks therefore tended to fare well on a risk-adjusted basis. It is this positive experience that is shaping most investors’ approach to inflation today.
However, this might not be the best way to address inflation risk going forward: Stock-bond correlations tend to increase when inflation is either high or rising, as shown in Figure 1. This could be a big problem for investors worried about inflation because positive correlations essentially mean less effective portfolio diversification.
We believe inflation in the near future will be higher than in the recent past. U.S. CPI inflation has been above 2% for 12 consecutive months, and core personal consumption expenditures (PCE) is at the threshold of the Federal Reserve’s target of 2%. Since inflation is a lagging economic indicator, one may reasonably expect inflation to remain elevated in the next few quarters, reflecting the current acceleration in U.S. economic growth. PIMCO’s latest Cyclical Outlook forecasts U.S. inflation in the 1.5%–2.0% range in 2019. Furthermore, the possibility for inflation surprises has increased as the Federal Reserve, along with other major central banks, appears more comfortable with inflation running at or above the target, meaning that central banks are less likely to hit the brakes on growth even if inflation overshoots for some time.
Protecting portfolios from higher inflation and uncertain stock-bond correlations
PIMCO’s midyear asset allocation outlook, “Late-Cycle Investing,” notes that inflation is one of the four key investment themes at this stage of the business cycle. Yet, most investment portfolios may not be protected against inflation surprises (defined as the difference between realized inflation and inflation expectations from a year ago).
As Figure 2 shows, stocks, bonds and the traditional 60/40 stock/bond portfolio all have negative inflation betas such that when inflation surprises by 1%, the traditional 60/40 portfolio would lose 1.1%. Over the last several years, inflation has been surprising on the downside, and equities have been positively correlated with inflation surprises. Figure 2 shows how this recent trend hasn’t been the case over the long term. It is noteworthy that inflation surprises are not rare; in fact, we estimate that the probability for an upside inflation surprise today significantly exceeds the probability for a downside surprise, given recent new tariffs, continued trade tensions, late-cycle fiscal stimulus and robust consumer spending.
In today’s environment of elevated inflation, with risks skewed to the upside, we think investors should consider an allocation to the real assets shown on the right side of Figure 2: TIPS (U.S. Treasury Inflation-Protected Securities) or other sovereign inflation-linked bonds (ILBs), commodities, REITs (real estate investment trusts) and multi-real asset portfolios that have the potential to perform better during times of rising inflation. Figure 3 and the following sections delve further into these four potential inflation-hedging solutions.
TIPS/Inflation-linked bonds (ILBs)
These fixed income assets are generally expected to perform well when growth slows, and they are the only assets where inflation protection is contractually guaranteed: Their principal rises in line with inflation. We think two TIPS/ILB solutions merit special attention:
- Levered TIPS/ILBs: One drawback of TIPS/ILBs, typical of the highest-quality or “safe-haven” assets, is that returns are typically moderate. However, they are attractive assets to lever (due to low financing costs and collateral haircuts, on par with U.S. Treasury bonds); a levered approach can magnify return potential, while increasing inflation hedging. Further, an allocation to levered shorter-duration TIPS has the potential to achieve these with only modest volatility or increased risk. Note that investing in the front end of the TIPS yield curve does not reduce the inflation-hedging because that comes from any adjustments in the principal, no matter the maturity; the inflation-hedging properties of five- and 10-year TIPS are the same.
- TIPS/ILB overlays: An overlay of TIPS, ILBs or CPI swaps (instruments that transfer inflation risk from one party to another through an exchange of cash flows) can boost inflation protection, and using existing high quality, liquid portfolio assets as collateral means that only limited new cash/assets are required to fund the strategy. We find this to be a capital-efficient way to hedge inflation risk without having to choose between return potential and inflation protection.
Commodities typically perform well in the late stages of an economic expansion. They are highly sensitive to changes in inflation, and in some cases, they are the source of inflation surprises. For example, food and energy prices represent 23% of the headline U.S. CPI basket but drive 88% of CPI volatility (as of 30 June 2018). Not surprisingly, commodities have an inflation beta of more than five. Additionally, we believe that commodities will perform well in the near term as the sector has historically peaked only after an expansion ends.
Sizing of commodity exposure is important since the asset class typically has high volatility. There are many types of commodities strategies; we seek those that deliver high roll yield and continuously evolve to provide the potential for diversified sources of risk premia (alpha) and better beta. Similar to TIPS, commodities are an excellent asset class to consider for overlays and increased capital efficiency.
Real estate investment trusts derive the majority of their revenues from rental income and distribute 90% of their taxable net income as dividends (according to the IRS). Over the short term, REIT prices are correlated to equities and have low inflation beta. Over the long term, however, REITs can be an effective liquid proxy for physical real estate and tend to track inflation more closely; real estate rents and values tend to increase with inflation, which eventually passes through to REIT dividends and valuations. Furthermore, REITs have a low correlation to TIPS and to commodities (0.24 to both, as measured by correlation of monthly index returns for REITs, TIPS and commodities 1 from March 1997 to June 2018), making them a potentially attractive addition to a balanced portfolio of real assets.
Multi-real asset solutions
A thoughtfully diversified mix of real assets can be a “one-stop-shop” solution for investors seeking a dynamic, responsive inflation-hedging allocation. The potential benefits of this approach are reduced volatility, higher return potential and meaningful positive inflation beta if the allocations perform as expected.
By investing in a mix of TIPS/ILBs, commodities, REITs, currencies and gold, investors can potentially increase diversification and benefit from multiple sources of alpha, derived by actively managing within each inflation-fighting asset class and making tactical moves across asset classes.
Key takeaways: seek to reduce inflation risk without sacrificing return potential
Milton Friedman once said, “Inflation is the one form of taxation that can be imposed without legislation.”
We at PIMCO spend countless hours studying and forecasting inflation and designing solutions that aim to protect investment returns from inflation “taxation.” We view inflation not only as a challenge, but also as an opportunity to generate strong absolute returns and alpha.
If inflation surprises to the upside in the years ahead, stock-bond correlations may increase, which would likely upset the inflation hedge that today’s dominant portfolio construction frameworks have derived from diversification in recent years. Drawing on the breadth and depth of PIMCO’s investment expertise, we have pinpointed four forward-looking inflation solutions that invest in real assets. Investing in single real asset classes, such as TIPS, commodities and REITS, or a multi-real asset solution, could provide a measure of protection for investors by hedging against inflation surprises, while also enhancing diversification and boosting return potential.
Please visit our inflation page for more of PIMCO’s views on the complex drivers of inflation globally.
CLICK HERE 1 REITs represented by DJ U.S. Select REIT Index; TIPS represented by Bloomberg Barclays U.S. TIPS Index; commodities represented by Bloomberg Commodity TR Index. Source: PIMCO, Bloomberg.