Rethinking Your Inflation-Protection Strategy

Art by Lars Leetaru

Tony Waskiewicz

One of the most challenging, but often critically important, tasks of a chief investment officer is rationalizing and explaining the results of portfolio exposures that are out of favor. Allocators facing the question “Why do you own anything other than Mega-Cap US Equities” can likely relate!

For allocators using a Growth / Inflation / Deflation (GID) asset allocation framework or for those with Consumer Price Index (CPI)-linked return objectives, you are likely facing uncomfortable conversations with your investment committee regarding the portfolio’s diversification to “I” or “I-linked” assets. Or perhaps you are ushering your committee through the process of updating strategic asset allocation targets and experiencing some consternation regarding your recommendation for inflation-protecting assets. 

Of course, holding diversifying assets is rooted in wisdom and sensibility, but that does not make the job of explaining the recent results of inflation-sensitive investments any easier. Defending the continued diversification to inflation-sensitive assets can be just as difficult (and potentially very unpopular).  

If you are an allocator needing the courage and a sound rationale underpinning an appropriate response to your investment committee’s concerns for holding diversifying “I” assets, here is a three-step process to consider:

Step 1: Openly acknowledge the many secular forces keeping inflation low.

Step 2: Avoid trying to predict future inflation and discuss the observable forces at work that could spark inflation.

Step 3: Redefine your approach to inflation protection by creating a customized inflation benchmark (versus using the traditional CPI-based approach).

By following these steps, you will likely conclude that your portfolio should maintain exposure to inflation-sensitive assets, but the overarching objective and types of investments used to achieve inflation-protection will be different going forward.

Here are some thoughts on how to put these steps in motion.

Step 1.

Openly acknowledge the many secular forces keeping inflation low.

In looking at the recent set of conditions, it would be easy to understand why an investment committee might question the merit of holding inflation-protecting assets. Technological advances, the broken association between unemployment levels and inflation readings (broken Phillips curve), secular changes in consumer behavior (i.e., the “sharing economy”), the waning ability for monetary policy to affect economic outcomes (lower rates have not meaningfully sparked an increase in aggregate demand of goods and services), and other structural forces have kept inflation persistently low.  

Your committee might also cite the significant opportunity costs associated with owning inflation-sensitive assets. In looking at the past returns of a typical basket of inflation-sensitive investments, it would be easy to understand their point of view (and their frustration). As the table below highlights, diversification to most inflation-sensitive assets has presented a headwind for portfolio results for most of the past decade.

Source: Data provided by Neuberger Berman

If the factors keeping inflation low remain in place, future returns of inflation-sensitive assets may continue to underperform other assets. If your investment committee strongly supports the view that inflation-protection is unnecessary, acknowledge that they may have a good case.

However, it would also be prudent to discuss the consequences of reducing or eliminating your portfolio’s diversification to inflation-sensitive assets.

Step 2.

Avoid trying to predict future inflation and discuss the observable forces at work that could spark inflation.

In their December 2019 “Mitigating Inflation Risk at Lower Opportunity Cost” white paper (a must read on the inflation risk topic), Olumide Owolabi and Apoorv Tandon of Neuberger Berman thoughtfully explain how experts consistently fail to accurately predict inflation levels. Their study shows how the University of Michigan’s one-year inflation expectation and the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters’ one year inflation expectation often differs significantly from the eventual realized US CPI. Their point is that even the most widely used models and economic experts cannot accurately predict inflation. As allocators, we should remind our investment committee of these prediction shortfalls and we should remain cautious on our ability to add value by making short-term tactical decisions regarding our portfolio’s weighting to inflation-protecting assets.  

Additionally, many investment strategists point to several forces that could shift the current low-inflation environment. One is Mercer’s not-for-profit practice CIO Chris Moore, who cites that “Governments are at a point where inflation is becoming a more attractive tool to manage their expanding debt levels. Additionally, as we look towards the next downturn and decreasing options central bankers have, fiscal stimulus and increasing deficits to stabilize growth look likely. In the US, monetary policymakers have started laying the concept for allowing inflation to run above its 2% target for a period of time as a way to compensate for recent years of below 2% realized. The combination of tolerant central banks and motivated governments, could very well be the ultimate catalyst for inflation.”

Another inflation factor possibly lying in wait is wage inflation. For more on this, I encourage allocators to read Justin Lahart’s January 2 Wall Street Journal article, “Demystifying Inflation’s Link to Employment.” Lahart explains how technology and persistently low inflation and low inflation expectations have conspired to shift and/or flatten the Phillips curve. However, he cautions against concluding that the Phillips Curve is permanently broken. “An economy in which wages and inflation don’t have something to do with the supply of labor would be a strange one,” said. Lahart. With unemployment hovering around 3.5% (at 60-year lows as President Trump reminds us) and many companies openly clamoring that workers are harder to find, perhaps we should not assume that wage inflation will remain benign.

While making a call on future inflation is challenging, we should all recognize that if these inflation factors do in fact take hold, our portfolio’s growth assets will face a natural headwind to future returns. If we eliminate our “I-sensitive” assets under these circumstances, what in the portfolio will work to offset the slowing or even negative returns of our growth assets? Will we regret eliminating our diversifying “I-sensitive” assets just when we need them most?

Maybe it’s best to avoid taking a stand on whether or not inflation-protection will be needed and rather think more specifically about inflation protecting strategies that help advance the mission of our respective organizations.

Step 3.

Redefine your approach to inflation protection by creating a customized inflation benchmark (versus using the traditional CPI-based approach).

Many investment policies cite “CPI + x%” as a return objective. Therefore, it is common for allocators to orient their inflation-sensitive strategies toward investments that seek to correlate to and/or outperform CPI. This approach is logical and traditional, but often leads to investment outcomes that disconnect from the economic sensitivities of an organization.

Linking investment objectives to CPI is rooted in the idea that a mission-focused institution needs to think in perpetuity and about its ability to preserve its purchasing power over long periods of time. A portfolio’s “I-sensitive” allocation intends to speak directly to the preserving purchasing power objective. Naturally, diversification of risk and return sources also supports the inclusion of inflation-sensitive investments.

However, linking an institution’s investment strategy to CPI may, in fact, create an economic disconnect for that institution because the approach assumes that the institution’s own unique mix of costs of goods and services is identical to that used to measure CPI. And rarely is this the case.

The CPI is a “measure of the average change over time in the prices paid by consumers for a market basket of consumer goods and services.” Your institution is a “consumer” and it buys its own unique  “basket of goods and services, “ which is very likely a different mix of  “market basket of goods and services “ than what is represented by the composition of CPI:  

• Housing 42%
• Food & Beverage 17%
• Transportation 17%
• Medical Services 7%
• Other 7%
• Apparel 6%
• Entertainment 4%

Take, for example, health care institutions. Many health care systems have recently experienced expense inflation that has accelerated much more rapidly than CPI (increased wage expenses associated with the competition for skilled nursing can be cited as one of the many causes).

In order to preserve its purchasing power, often measured by the Days Cash on Hand (DCOH) metric, a health care system must grow its investment reserves faster than the rate of increase of its daily expenses. The “basket of goods and services” that comprise a health care organization’s daily expense base is very different than the mix of goods and services represented in CPI. Therefore, a health care organization must protect against a unique set of inflation pressures other than what is expressed in CPI readings. If a health care organization’s daily expenses are accelerating faster than CPI, these institutions may still lose purchasing power (a deterioration in their DCOH metric) even if their investments outperform CPI. As such, a CPI-based investment objective may not be appropriate for these institutions.

What should institutions do to avoid this economic disconnect?

As Neuberger Berman’s Owolabi and Tandon suggest in their white paper, “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.” In the case of the health care investors, it would be sensible to establish an investment objective focused on protecting against the specific inflation pressures to which it is exposed. A university endowment portfolio would be structured to protect against an entirely different set of inflation sources and a foundation portfolio may only need to offset one or two inflation factors specific to the cause for which they are supporting.  

To implement the great advice of Owolabi and Tandon, an institution should examine its cost base to identify the most significant factors driving their expenses (or future obligations in the case of a foundation). Once identified, these expense factors can be used to construct a customized inflation index. This new index can act as the basis for the “I” or “I-linked” investment strategy. The job of the investment team will be to find and select a mix of investments that best fit the risk and return characteristics of this new customized index.

Because each institution purchases its own unique set of  “goods and services,” each institution will have its own unique inflation-protection investment strategy (and therefore its own portfolio of investments). Ultimately, a well-constructed, customized  inflation-sensitive allocation will possess risk and return factors that correlate to the economic needs and sensitivities specific to that organization. This customization will maximize the probability that the organization will be able to preserve its purchasing power over the long-term. If you find yourself thinking this approach loosely resembles how pensions view asset/liability matching, you are thinking correctly.  

However, implementation of this approach may not be easy. Identifying the best fit investment for each of your institution’s expense factors could require substantial research, back-testing, and forward-looking scenario analysis. You may even need to get creative with your product and manager selection in order to build a portfolio that matches the factors expressed in your newly constructed customized benchmark. For example, in their white paper, Owolabi and Tandon conclude that the S&P 500 Biotechnology Select Industry equities sector 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 more logical and have a better economic fit for your institution’s inflation factors than the current mix of investments currently represented in your inflation-sensitive composite (for example, how much does your institution’s expense base really correlate to that commodities exposure you maintain in the portfolio?). You may find that a prudent, customized solution will require a few unexpected, but very well thought out, new line items.  If you cannot run the required analytics in-house, task your consultant with a project to identify investments that correlate to the expense factors you have identified for your institution.  

It’s important to note that the development and implementation of a customized inflation index does not preclude an investor from holding some traditional inflation-sensitive 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.  

Nevertheless, if Step 3 is followed, chances are your new inflation index will look very different than CPI. And your new “I” allocation will look very different than your prior allocation. While implementation of this customized approach will require significant analysis, independent thinking, and thought leadership, at least your new “I” allocation can be prudently justified as one that will move in tandem with the economic sensitivities of your organization.

Moreover, this customized approach steps aside of the need to make a call on inflation. Rather than trying to predict inflation, this approach seeks to maximize each institution’s ability to protect its own unique purchasing power. Even during periods in which the institution’s new mix of “I-sensitive” investments are out of favor, the institution is still able to maintain its purchasing power since its costs should be acting similarly.

You now have a strong basis to justify the existence and makeup of your “I” and “I-linked” investments. What investment committee would argue with that? Well, maybe the one asking why you own anything other than Mega-Cap US Equities. And I can’t help you with that!  

Data Sources:

Equity

• S&P 500 = S&P 500 Index Total Return
• Materials = S&P 500 Materials Sector Total Return
• Energy = S&P 500 Energy Sector Total Return
• Emerging Market = MSCI Emerging Markets Index

Fixed Income

• TIPS = Bloomberg Barclays U.S. TIPS Total Return Index
• Leveraged Loans = Credit Suisse Leveraged Loan Index

Commodities

• Raw Commodities = Bloomberg Commodity Index Total Return
• Precious Metals = S&P GSCI Precious Metals Total Return
• Industrial Metals = S&P GSCI Industrial Metals Total Return
• Gold =Bloomberg Gold Spot Exchange Rate

Real Assets

• REITs = FTSE EPRA NAREIT All Equity REIT Total Return
• Core Real Estate = NCREIF NFI OEDC
• Non-Core Real Estate = NCREIF NPI
• MLPs = Alerian MLP Index Total Return
• Infrastructure = FTSE Global Core Infrastructure
• Global Natural Resources = S&P Global Natural Resources

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