Inflation Regime Shifts: Implications for Asset Allocation
Nicholas J. Johnson, Sebastien Page
In the case of gold, some may question its ability to continue to hedge against inflation given its relatively lofty price today. However, we believe gold’s valuation is not overly stretched, instead it reflects a world of continued financial repression and negative real interest rates both in the U.S., and globally. As such, we believe gold, which is essentially a currency without a printing press, will maintain its historic correlation to changes in inflation.Currently there is little in the way on inflation pressures with core inflation running in line with its average of the last 20 years. While it is hard to say with certainty when inflation will move higher, we can identify some of the potential catalysts. A commodity supply shock, such as the closure of the Straits of Hormuz or widespread regional unrest in the Middle East, is one near-term catalyst that could move inflation materially higher. Recall that in the inflationary episode of the 1970s, it was the Arab Oil Embargo in 1973 that caused inflation to double from 5% to 10%. Absent a commodity price shock, the other likely catalyst to move inflation expectations higher is a gradual economic rebalancing and recovery. As the economy recovers, we expect aggregate demand to increase and the level of unemployment to decrease. As this happens, the Fed will be faced with making a tradeoff between the two components of their dual mandate, price stability and full employment. It is in making this tradeoff during the coming economic recovery that we see the catalyst for inflation. The Fed may err on the side of seeking greater employment and a stronger recovery, believing that temporarily higher inflation can be reversed. However, prior inflationary episodes suggest that reversing prior easing and its impact on inflation expectations may not be as easy as just undoing prior accommodative policy.When we look forward, over the next several years we see a world of below-average growth and above-average inflation as the developed world continues to deleverage. Central banks globally have been engaged in a series of unconventional policy measures and competitive currency devaluation. Ultimately, these actions have created an inflationary tail risk.
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Inflation-linked bonds (ILBs) issued by a government are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. Government. Certain U.S. Government securities are backed by the full faith of the government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value.Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. The correlation of various indices or securities against one another or against inflation is based upon data over a certain time period. These correlations may vary substantially in the future or over different time periods that can result in greater volatility. It is not possible to invest directly in an unmanaged index. Hypothetical and simulated examples have many inherent limitations and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated results and the actual results. There are numerous factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results. No guarantee is being made that the stated results will be achieved. This material contains the opinions of the authors but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are registered and unregistered trademarks of Allianz Asset Management of America L.P. and PIMCO, respectively, in the United States and elsewhere. ©2012, PIMCO.
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