Although there has been significant discussion of deflation risk in the current volatile global economy, investors also should prepare for inflationary pressures in the years to come.
"Since the days of the Volcker-led Federal Reserve, we've lived in an environment of tamer reported inflation," said Mark Carlson, fixed-income investment strategist at Northern Trust. "While the near-term outlook may be focused on deflation, deflationary cycles are historically short. You always have to be mindful that inflation will return. Experienced portfolio managers are looking at this issue now, primarily because timelines for economic recovery are so uncertain."
Now, it's important to keep in mind: The calculation and reporting methods for U.S. inflation data were changed in 1980. As a result, the inflation data reported since 1980 have been lower compared to previous methodologies. Yet, no matter the calculation and methodology used, the long-term trend remains the same: The U.S. economy has experienced more frequent inflationary periods than it has deflationary periods.
While deflationary concerns are a hot topic among media pundits, it's important to maintain proper perspective: U.S. deflationary periods are infrequent and relatively short.
For example, the last major deflationary period in the United States occurred between 1928 and 1933, the earliest days of the Great Depression. Since then, brief deflationary cycles have occurred — with one of the two most significant deflationary cycles of the past 60 years occurring in the fourth quarter of 2008 and first half of 2009.
Given the statistical unlikelihood of a prolonged period of deflation, now may be an opportune time for investors to revisit their inflation-hedging strategies. Certain investments and strategies may offer investors a degree of protection – or hedge – against inflation risk. For example:
Treasury Inflation-Protected Securities (TIPS): These U.S. Treasury-backed securities are indexed to inflation to protect investors against the negative effect of inflation. Their par value rise with inflation, as measured by the Consumer Price Index (CPI), but their interest rate remains fixed.
Exchange-Traded Funds (ETFs): These securities generally track an index, a commodity or group of commodities, or an asset class such as natural resources or equities. ETFs are similar to an index fund, but they trade like a stock on an exchange, registering price changes throughout the day. For inflation protection, many investors invest in ETFs tied to TIPS.
Over-the-Counter Inflation Derivatives: Often called inflation swaps, these OTC derivatives can be used to transfer inflation risk from one party to another. Typically, one party's cash flows are linked to a price index; the other is linked to a conventional fixed or floating cash flow.
Real Assets: Real estate, natural resources, commodities and infrastructure investments all have meaningful correlations with inflation, as macro economic growth leads to increased demand for raw materials and subsequent increases in prices for these hard assets.
Inflation-Oriented Investing: A Closer Look
Investors who are concerned about inflation risk – and its potential impact on their portfolios – should consider a combination of inflation hedges that might include a mix of TIPS and exposure to natural resources and long-term assets. Mixing inflation hedges can result in a balanced strategy against the various cycles of inflation.
In the chart below, we take a closer look at many asset classes that, traditionally, have been used as inflation hedges. Over the 10-year period examined, these "traditional" hedges have exhibited low correlations to inflation.
As you can see, there are advantages and disadvantages to each hedging strategy when only an individual strategy is employed.
- Research has shown that TIPS are effective hedges against inflation in the near term, but over the longer term returns from real interest rates overwhelm the inflation return component.
- Gold has long been viewed as an inflation hedge, but the data proves otherwise with very low correlation to inflation during the past 10 years.
- While commodity futures have the highest correlation to inflation, futures are undergoing regulatory and market changes that are likely to make investing in these products more difficult and with less market liquidity.
But, through careful planning, an investor can capitalize on the advantages these strategies offer by combining them into a balanced – and effective – inflation-risk-mitigating portfolio.
Evaluating the Unknowns
With continued volatility in the global markets and uncertainty over government policy, the need for long-term inflation planning persists. Now, more than ever, investors need a carefully crafted strategy to hedge against inflation.
With this in mind, Northern Trust's experienced investment managers and economic strategists are currently monitoring three global trends very carefully as they assess the inflation climate:
Emerging Markets: Once the global economic engine starts to accelerate, and emerging markets get their balance sheets in order, we expect to see price growth in natural resources, infrastructure materials, food and support materials like fertilizer.
Short-Term Inflation Growth: Since prices are already rising, we would expect to see an initial inflation spike that will need to be addressed. It's important to keep in mind: inflation hedging involves looking at both long- and short-term inflation behavior.
Potential for Policy Error: In the United States, the pending recommendations by the Super Committee on Debt of Congress and then the upcoming election might provide the greatest uncertainty for investors as heated wrangling over tax and spending policies continue. We believe that if proposed taxes on certain goods and services succeed, they may become a significant inflation driver.
Against this backdrop of economic and political ambiguity, prudent investors are wise to review their inflation-hedging strategies.
"Look at the market, commodity and inflation/deflation volatility of the past three years," Carlson said. "Until some certainty is reached regarding the new structures of capital markets, banking sectors and consumer balances sheets, it is important for investors to frequently review and match their inflation hedges against long-term investment goals and related asset/liability allocations."