In this edition, Chris Brightman, chief executive officer and chief investment officer of Research Affiliates, explains their outlook on long-term inflation and discusses how investors can prepare for this risk. Cam Harvey, partner and senior advisor of Research Affiliates, discusses whether bitcoin could be an inflation hedge. As always, their insights are in the context of the PIMCO All Asset and All Asset All Authority funds. Please note: The All Asset Funds and their underlying holdings in PIMCO Funds do not invest in cryptocurrencies generally or bitcoin specifically. All Asset All Access is published quarterly.
Q: What is Research Affiliates' outlook on inflation, and what informs this view?
Brightman: Wiring trillions of newly created U.S. dollars directly into peoples’ bank accounts tends to reduce the value of dollars relative to goods, services, and real assets. June and July’s year-over-year change in U.S. CPI (Consumer Price Index) was 5.4%. Housing prices jumped 18% in May from a year earlier, according to the Federal Housing Finance Agency. In Research Affiliates’ view, fiscal policy now being enacted in Washington creates a material risk of today’s soaring inflation continuing into the years ahead.
In stark contrast, the bond market is pricing forward inflation rates to remain stable at just above the Federal Reserve’s 2% target, according to the markets for U.S. Treasury Inflation-Protected Securities (TIPS). This benign market price for inflation implicitly assumes that recent extraordinary spending financed by Fed purchases of U.S. Treasury debt will prove transitory. We believe it also presents an opportunity to cheaply hedge inflation risk.
Before talking about how to hedge wealth from inflation, let’s take a quick look at the big picture of fiscal inflation risk in the U.S. As more baby boomers age, retire, and die, more millennials are beginning to govern. Policy appears to be shifting toward younger voters’ general preference for more generous social benefits and a secular increase in U.S. government expenditures toward European norms. From 1960 to 2020, total U.S. government spending (all levels) averaged 33% of GDP.Footnote1 In contrast, average government spending in the world’s 18 other advanced economies averaged 46% of GDP over that time frame. In France, Belgium, Sweden, and Denmark, average spending exceeded 50% of GDP. Only Switzerland spent less than the U.S.
Would a secular increase in U.S. government spending of approximately 10 percentage points of GDP cause inflation? The answer depends upon whether the increased spending is funded by taxes or money printing. Spending funded by tax receipts generally doesn’t create inflation. Worryingly, receiving checks from the government is widely popular, while very few voters will tolerate their taxes going up. Will U.S. politicians give people what they want by raising spending but not taxes?
To be sure, our government currently intends to raise income tax rates for corporations and the wealthiest 1%, and may even try to collect wealth taxes. Whatever the merits of this tax policy from a distributional perspective, it won’t raise the necessary revenue, in our view. Raising tax receipts to above 40% of GDP in a developed, democratic country without enacting a broad-based consumption tax has never been accomplished, according to our research. If the U.S. government funds a substantial secular increase in social spending through Fed purchases of Treasury debt or direct money creation as advocated by Modern Monetary Theory (MMT), then an inflation shock like the U.S. last experienced in the 1970s seems inevitable, in Research Affiliates’ view.
Q: How might investors reposition their portfolios to prepare for potential longer-term inflation risk?
Brightman: My colleague, Cam Harvey, partner and senior advisor to Research Affiliates, studied inflation surges over a 95-year span in a recent analysis called “The Best Strategies for Inflationary Times.” In his study, he analyzed how inflation affects a variety of asset classes in the U.S., U.K., and Japan. His study found that when unexpected inflation exceeds 5%, conventional asset classes, notably U.S. stocks and bonds, tend to fare poorly.
To prepare for inflation risk, investors can consider repositioning portfolios by selling bonds, borrowing at long-term fixed interest rates, and investing in inflation-hedging asset classes (i.e., those that historically tend to perform well in inflationary environments), such as commodities, real estate, resource stocks, and emerging market equities and bonds.
Many of these asset classes currently appear cheaper based on Research Affiliates valuations and may offer higher long-term estimated returns relative to mainstream stocks and bonds in the base case and especially if inflation rises, according to Research Affiliates’ models.
Q: Is bitcoin an inflation hedge?
Harvey: Bitcoin is just one of many cryptocurrencies, which vary widely in their design, features, risks, and supply and demand dynamics. However, bitcoin’s prevalence means many investors focus on it, and many ask whether it could be another way to hedge inflation risks.
In contrast to central bank fiat currencies, bitcoin’s supply is algorithmic. Currently, 6.25 bitcoins are produced approximately every 10 minutes. The rate of production halves roughly every four years, and by 2140, no new bitcoin will be produced (barring any change in the algorithm). Given that the supply of bitcoin is independent of any central bank or government policy, many observers have argued that bitcoin is an attractive inflation hedge.
At Research Affiliates, we see many reasons to be suspicious of this theoretical argument.
First, the case is theoretical because bitcoin has not yet been empirically tested. Bitcoin has been around for only 12 years, and quality data exist for only about eight years. During this short period, we have not experienced a persistent surge in inflation. Hence, bitcoin is untested in an inflationary crisis.
Second, the U.S. CPI inflation rate is 5.4% (annualized as of the end of July 2021), much higher than the Fed’s current target. This higher rate does not yet qualify as an inflation surge because many of the components may be transitory.
Nevertheless, many investors believe inflation risk has increased. How has bitcoin performed as inflation risk has increased in 2021? Take, for example, the annualized U.S. CPI inflation rate, which was 4.2% as of April 2021, and then rose to 5.4% as of both June and July. Inflation expectations also rose over that time frame, and remain elevated. Over the same period, bitcoin’s value dropped from a peak of over $62,000 in April to below $42,000 as of the end of July.
Third, we believe bitcoin is far too volatile to be a reliable hedge against unexpected inflation. In my previous research on gold,Footnote2 I demonstrated using a long sample of historical data that gold tends to be unreliable as an inflation hedge for short- and medium-term horizons, because it is too volatile. Over its relatively brief existence, bitcoin has displayed five times the volatility of gold. So if gold is unreliable, bitcoin is likely to be even more unreliable,Footnote3 in Research Affiliates’ view.
Fourth, although bitcoin’s value is supposedly independent of economic activity (e.g., GDP, money supply) that tends to be an important driver of financial markets, in bitcoin’s short history it has not always acted as if it is independent. Consider its performance during March 2020 amid the worst of the COVID-19 market shock. The S&P 500 shed over 30%. Investors dumped gold, which then fell 12%. Bitcoin plunged 55%. In this classic “risk-off” environment, investors disposed of risky assets and sought the perceived “safe haven” of U.S. Treasury bonds. Subsequently, as the COVID-19 outlook became less dire, U.S. stocks climbed to record highs, gold rose to its third- highest level in history, and bitcoin rocketed to a record level of $62,000. In Research Affiliates’ view, this appears consistent with bitcoin being yet another speculative asset – like stocks – rather than a “safe haven” asset or a reliable inflation hedge.
Some investors in countries that tend to experience extreme inflation may still look to cryptocurrencies as a potential inflation hedge. Even in such countries, however, we believe citizens may want to consider a U.S.-dollar-collateralized crypto token or “stablecoin.” (Stablecoins are cryptocurrencies whose value is designed to be pegged to a fiat currency, cash equivalent, exchange-traded commodity, or other asset.)
In Research Affiliates’ view, investors do not necessarily need to avoid crypto assets.Footnote4 Indeed, it is difficult to ignore any asset class with nearly $2 trillionFootnote5 in market capitalization (as of July 2021), and many investors choose to have some exposure to crypto in a well-diversified portfolio. Investors who invest in bitcoin expecting inflation-hedging properties, however, are likely to be disappointed.
For further insights, please watch this video on current investment themes and the All Asset strategies with Rob Arnott, founder and chairman of Research Affiliates, and John Cavalieri, asset allocation strategist at PIMCO.
The All Asset strategies represent a joint effort between PIMCO and Research Affiliates. PIMCO provides the broad range of underlying strategies – spanning global stocks, global bonds, commodities, real estate, and liquid alternative strategies – each actively managed to maximize potential alpha. Research Affiliates, an investment advisory firm founded in 2002 by Rob Arnott and a global leader in asset allocation, serves as the subadvisor responsible for the asset allocation decisions. Research Affiliates uses their deep research focus to develop a series of value-oriented, contrarian models that determine the appropriate mix of underlying PIMCO strategies in seeking All Asset’s return and risk goals.