Tony Waskiewicz
Inflation is DEAD! OK, I’m not really certain if inflation is dead, but I do know that the traditional approach to inflation protection is. This article explains why traditional inflation-protection strategies have failed and revisits an enhanced approach to inflation protection that was described in an article published earlier this year.
First, recall that in early 2020, the inflation topic was relevant. Coming out of 2019, allocators were appropriately contemplating what persistently low rates, a growing economy and bloated stock and bond prices would mean for future Consumer Price Index (CPI) readings and other inflation indicators.
I had just completed some work on the inflation topic, which Chief Investment Officer was excited to publish. Sure enough, after weeks of planning and with no reason to think that the inflation topic would become irrelevant, the article was published on March 12. Yes, that was the same day that the Dow Jones Industrial Average (DJIA) sank 2,352 points, a decline of 9.9%, which at the time marked the single largest point drop in the history of the DJIA (only to be eclipsed a few days later when on March 16 the DJIA dropped 2,997 points, or 12.9%). As pandemic fears swelled and panic raged, the last thing on the investors’ minds was inflation protection. The editors of Chief Investment Officer and I had to chuckle about the timing of the article and about the fact that the inflation topic had indeed become irrelevant.
Fast forward a few months. Inflation has re-emerged as an important, and even divisive, topic for allocators. In a June article, CIO’s Larry Light adeptly captured the views of several allocators and economists that inflation would not be a concern. Then, on Aug. 27, the Federal Reserve announced a change in its stance regarding its 2% inflation target. The new policy essentially commits the Fed to refraining from monetary tightening until inflation stays consistently above its 2% target following periods in which inflation runs below the 2% target.
On Sept. 11, Light wrote a follow-up article describing Stanley Druckenmiller’s view that the Fed’s new policy, among other forces, will spur high or even hyper-inflation in the years to come. “I think we could easily see 5% to 10% inflation in the next four or five years,” Druckenmiller said.
There is no clear consensus on the direction of inflation or how the Fed’s new policy will affect CPI (or the markets more broadly), but, clearly, the need to re-examine inflation-protecting strategies is a priority for allocators. Given the renewed attention on inflation, this is a good time to re-share some thoughts on how to build an effective inflation hedging portfolio.
Below, I seek to explain why and how allocators should pivot away from the traditional inflation-protecting techniques that are tied to CPI in favor of a customized inflation strategy directly tied to the organization’s cost structure.
Redefining Your Approach to Inflation Protection
Many investment policies cite “CPI + x%” as a return objective. Linking investment objectives to CPI is rooted in the idea that most mission-focused institutions seek to exist in perpetuity and, to do so, they must preserve their purchasing power. Inflation-hedging strategies seek to help the institution meet the preservation of purchasing power objective. Given the organizational and investment policy objectives, it is common for allocators to orient their inflation-sensitive strategies toward investments that have a high correlation to CPI.
However, linking an investment strategy to CPI may, in fact, create an economic disconnect for many institutions. A CPI-linked strategy assumes that the mix of goods and services required to operate the institution are identical to the mix of goods and services represented in CPI. And rarely is this the case—as I can attest.
I spent several years watching my portfolio’s traditional inflation-protecting instruments struggle while the organization I served faced significant cost pressures stemming from rising labor inflation and the effects of rising health care costs. I was experiencing the worst of both worlds—the portfolio’s CPI-linked investments created a headwind to performance, while the organization I served needed outsized portfolio gains to keep the institution’s purchasing power in line with the rampant rise in its cost of doing business. My portfolio’s CPI-linked assets were not hedging the inflation being experienced by my organization. It became clear that the traditional methods of protecting against inflation were not suitable and that I needed to develop a more effective approach for my organization.
As part of developing a different approach, I examined the makeup of CPI and compared it to the expense structure of my organization. According to the US Bureau of Labor Statistics (BLS), CPI measures “the change in prices paid by consumers for goods and services.” To calculate the “change in prices paid by consumers for goods and services,” the BLS has constructed as basket of goods weighted as of August as:
- Housing: 42%;
- Food and beverage: 15%;
- Transportation: 15%;
- Medical services: 9%;
- Education/communication: 7%;
- Entertainment/recreation: 6%;
- Apparel: 3%; and
- Other: 3%.
My institution purchased its own unique basket of goods and services, which was very different than the basket of goods and services being measured by CPI. Therefore, the CPI-linked inflation-protecting strategy that I had implemented was not an effective inflation hedge for the institution. Chances are that your organization faces the same challenge. What can an allocator do to address this challenge?
Creating a Customized Inflation Benchmark
In their “Mitigating Inflation Risk at Lower Opportunity Cost” white paper from December (a must read on the inflation risk topic), Olumide Owolabi and Apoorv Tandon of Neuberger Berman thoughtfully explain that, “We all buy different things and therefore experience different inflation. Therefore, it is advisable to create an inflation benchmark tailored to each investor before designing a portfolio solution.”
To implement the advice of Owolabi and Tandon, an institution should examine its own unique cost base to identify the most significant factors driving the organization’s expenses. Once identified, these expense factors can act as the basis for a customized inflation index upon which the organization can build and implement its own unique inflation-protection investment strategy.
Once the customized benchmark is constructed, it will be the job of the investment office to find and select a mix of investments that best fits the risk and return characteristics of this new, customized index. Ultimately, a well-constructed, customized inflation-sensitive allocation will possess risk and return factors that correlate to the cost structure and economic sensitivities specific to the organization. The customized approach increases the probability that the organization will be able to preserve its purchasing power over the long-term.
Although this customized approach may seem sensible or even obvious, implementation of such an approach is not easy. Identifying the best fit investment for each of your institution’s expense factors requires substantial research, back-testing, and scenario analysis. The investment office may need to get creative in order to build a portfolio that maintains a high correlation to the newly constructed customized benchmark. For example, in their white paper, Owolabi and Tandon conclude that the S&P 500 Biotechnology Select Industry Index has a high correlation to the costs faced by health care providers. A biotech investment as part of the “I” allocation? As odd as it may seem, such an investment may actually be a more logical choice and have a better economic fit as an inflation hedge than the current mix of investments in your inflation-sensitive composite. For example, how much does your institution’s expense base really correlate to the commodities exposure in the portfolio?
It’s important to note that the development and implementation of a customized inflation index does not preclude an investor from holding some traditional CPI-linked assets. An allocator may have other portfolio needs, such as the need for income or uncorrelated growth factors, which could justify owning some of the more traditional inflation-sensitive assets. An investor seeking income or growth from these investments is speculating that these future return sources will be achieved (versus hedging inflation). If these investments have little to no correlation to your organization’s cost of doing business, then recognize the level of speculation (versus hedging) you are acting upon and the importance of underwriting these investments with the other objectives in mind. It will not be a surprise if this new approach shifts your view on traditional inflation hedging asset classes such as Treasury inflation-protected securities (TIPS), commodities, master limited partnerships (MLPs), real estate, and energy.
Conclusion
I have no idea if inflation is dead. But I do know that if you continue to use TIPS, commodities, MLPs, real estate, and energy in your inflation-sensitive allocation, and your organization’s operating expenses have little to no correlation to these factors, you are not hedging inflation but rather simply speculating on the future returns of these assets. If these assets, and other assets in your portfolio, underperform while the expenses of the organization increase, you could be exposing your organization to the significant risk that it will experience the erosion of its purchasing power.
So whether Druckenmiller is right or wrong about inflation hitting 5% to 10% in four to five years, you can help your organization achieve its objective to exist in perpetuity by developing and implementing a customized inflation-protecting strategy. Although such an approach will require significant analysis, unconventional thinking, and thought leadership, at least the approach can be prudently justified as one that maximizes your institution’s ability to preserve its purchasing power.
Hopefully, if you implement this approach, you can avoid the “worst of both worlds” experience that I encountered.
Tony Waskiewicz has nearly 30 years of financial services, investment advisory, and CIO experience and most recently served as chief investment officer for Mercy Health in St. Louis.
This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Institutional Shareholder Services or its affiliates.
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Rethinking Your Inflation-Protection Strategy
The Fed Will Trigger Hot-Running Inflation, Druckenmiller Warns
Remember Those Rate Increases? Big Mistake, Two Fed Governors Now Say
Tags: CPI, Druckenmiller, Inflation, Returns, Tony Waskiewicz