After two decades of stable inflation in the U.S., many investors have relaxed their vigilance – even though unanticipated inflation can significantly harm investment returns. Today, as long-term inflationary risks loom, we believe investors may benefit from reassessing their portfolios’ sensitivity to inflation. PIMCO has designed the Inflation Response Multi-Asset Strategy (IRMAS) to enhance portfolio responsiveness to inflation.
The strategy seeks to take advantage of inflation and improve real (inflation-adjusted) returns. It aims to do this by incorporating asset classes that have historically responded well to inflation, especially to unanticipated increases, while tactically managing for what is causing inflation and how inflation is priced into each asset class. All asset classes already have some degree of inflation expectation built into their prices, and changes in those expectations can influence asset prices.
We have found that over the last 40 years, both stocks and bonds have tended to respond negatively to inflation surprises – inflation in excess of what is already priced in and anticipated. This is especially relevant today because we see the long-term risk of inflation increasing, but the market has not yet priced in higher inflation expectations. As a result, we believe this is a good time to incorporate inflation hedging and realign the inflation sensitivity of portfolios.
Risks of higher inflation
Inflation in the U.S., as measured by the Consumer Price Index or CPI (which estimates the average change in prices for a basket of goods and services), averaged a fairly benign 2.5% in the two decades from September 1992 through September 2012. However, PIMCO expects U.S. inflation to trend higher over the next three to five years, mainly due to three forces:
- Poor fiscal conditions and heavy debt loads in the U.S. and other developed countries
- Prolonged accommodative and unconventional monetary policies
- Continued stress on global commodity supplies from emerging market demand growth
Inflation-sensitive asset classes
PIMCO’s Inflation Response Multi-Asset Strategy incorporates five critical asset classes that have historically responded positively over different time frames to inflation and inflation surprises (as shown in Figure 1).
- Treasury Inflation-Protected Securities (TIPS) are U.S. Treasury bonds whose value is contractually linked to CPI. TIPS therefore typically respond to a wide range of inflation sources and can act as a cornerstone of an inflation-hedging portfolio, hedging against increases in wages, education costs, medical expenses and more. In our view, they are most effective at hedging portfolios in a low-growth and high-inflation environment.
- Commodities may help hedge against rising food and energy prices, which comprise a quarter of CPI and are its most volatile components. Commodity investments can therefore act as a shock absorber for inflation surprises.
- Real Estate Investment Trusts (REITs), which invest in income-producing properties and pay dividends, offer a potential defense against increases in the costs of housing, which make up over 30% of CPI. While REITs have a high correlation to inflation over longer time periods, they have a high correlation with equities over shorter time periods.
- Non-dollar currencies may help combat inflation driven by higher prices for imported goods which are brought about by a weaker U.S. dollar.
- Gold has characteristics of both a commodity that is easily stored for a long period of time and a currency. It may help provide value in the event of competitive currency devaluations.
(For more details on how various asset classes respond in different inflationary environments, including periods of high inflation and inflation surprises, please see “Inflation Regime Shifts: Implications for Asset Allocation,” by Nicholas Johnson and Sébastien Page.)
Bonds and stocks, on the other hand, have historically responded negatively to surprises in inflation. Bond prices tend to fall because inflation erodes the value of investments with a fixed income, or yield; it is also associated with rising interest rates. In theory, bonds with yields linked to short-term interest rates, such as Treasury bills, could move in tandem with inflation, but with the Fed pegging short-term rates near zero since late 2008 and likely to hold rates there through 2015, short-term instruments have become generally unresponsive to inflation.
The negative relationship between equities and inflation surprises may not seem as intuitive. Think of equities as a discounted stream of future cash flows. When inflation rises, the discount rate applied to those cash flows rises, which lowers their current value. Higher interest rates also increase the cost of capital to corporations, and higher inflation means that earnings may be overstated since they depreciate historical cost rather than replacement cost of assets. While equities can serve many critical investment objectives (such as higher return potential), they tend to leave an investor with a negative inflation beta. However, an active equity manager can help by carefully focusing on companies with enough pricing power to counter the negative impact of higher inflation.
Measuring asset class sensitivity to inflation
By thoughtfully combining assets – considering risk, return, inflation sensitivity and the contributing factors of inflation – PIMCO developed the Inflation Response Index (Bloomberg ticker: INFNRSPN). This index is composed of 45% TIPS, 20% commodities, 15% currencies, 10% REITs and 10% gold. (These asset classes are represented respectively by: Barclays U.S. TIPS Index; Dow Jones UBS Commodities Total Return; J.P. Morgan Emerging Local Markets Plus; Dow Jones Select REITs; and Dow Jones UBS Gold Subindex Total Return.)
From the early days of the TIPS market in early 1997 through September 2012, the index returned 7.7% annually, over five percentage points higher than the annual rate of inflation for the same time frame, with a modest volatility level of 7.7% and a monthly inflation beta of 2.9.
To show how an inflation-sensitive portfolio would have performed over a longer time period that includes different economic scenarios, with both rising and declining interest rates as well as periods of higher inflation, PIMCO simulated returns as far back as all the index data were available, from the second quarter of 1973. This includes a simulation of historical TIPS performance to capture a more robust timeframe than the period since TIPS were introduced in 1997, which has been dominated by declining real rates. Of course, future periods may have very different inflation dynamics than those since 1973, and historical returns may not be indicative of future ones.
We found that by including just a 20% allocation to this Inflation Response Blended Index Model in a portfolio of 70% stocks and 30% bonds (reducing the allocations to 60% and 20%, respectively), the inflation beta of the portfolio increased from -1.62 to -.85. (Inflation beta quantifies the magnitude of an asset’s response to inflation; for every 1% change in the rate of inflation, returns move by a multiple reflected by its inflation beta.) Since early 1973, the Inflation Response Blended Index Model alone returned 9.4% – about five percentage points over the average annual 4.3% rate of inflation.
When added to a portfolio of stocks and bonds, the inflation-sensitive index model portfolio increased the inflation beta of the full portfolio, reduced the overall volatility profile and improved risk-adjusted returns, as illustrated in Figure 2.
Opportunities for active management
In addition to using the weighting methodology of the Inflation Response Index, the Inflation Response Multi-Asset Strategy seeks to add value by taking advantage of PIMCO’s active management capabilities. Tactical allocation among the different asset classes can help position the portfolio to respond to the particular sources of inflation in a given economic environment. In addition, the strategy aims to find relative value opportunities when anticipated economic environments or inflation are priced differently among various asset classes.
Within each asset class, we also see opportunities for active management. PIMCO’s real return team has a time-tested history of managing each asset class, combining the firm’s top-down global macroeconomic views with bottom-up research on each asset class.
The strategy incorporates tail-risk hedging, which aims to manage the risk of extreme events, such as a financial crisis, when a single risk factor can have a significant impact on portfolio value. The tail-risk hedge seeks to reduce overall portfolio risk, creating opportunities to use capital more effectively when prices are cheaper.
A comprehensive inflation solution
With inflation risks increasing over the secular horizon, we think investors should evaluate their portfolios’ ability to deal with a rise in inflation. Typical investment portfolios contain a heavy mix of stocks and bonds, which tend to respond negatively to inflation surprises, leaving them ill-prepared for a move higher in inflation. PIMCO’s Inflation Response Multi-Asset Strategy offers a solution that is designed to enhance responsiveness to inflation, improve diversification and provide better risk-adjusted return potential. By investing in multiple inflation-sensitive asset classes while managing volatility, hedging tail risk and seeking value via active management, IRMAS aims to better position investors’ portfolios for inflation.
Thanks to our PIMCO colleague Kate Botting for her contributions to the analysis in this article.