Here Today, Gone Tomorrow? Three CIOs Sound Off on Inflation
Art by Julien Posture
Last week, the Bureau of Labor Statistics (BLS) revealed that the Consumer Price Index (CPI) had risen 7% in December from the previous year, the highest number reported for the inflation metric in 39 years.
For institutional investors, inflation is the latest challenge in an already volatile market environment. But just how bad will it get and how long will it last? And perhaps even more importantly, how are investors hedging against it?
CIO magazine spoke to three chief investment officers about their strategies regarding inflation, each with a different take on how to best protect their assets. We also spoke to an academic economist with a background in Wall Street forecasting and a quantitative analyst at AlphaSimplex to try and paint a best guess of what will happen next.
Sean Bill, CIO, Santa Clara Valley Transportation Authority (VTA): “There’s still more pent-up inflation in those numbers that has not yet hit the indexes.”
Sean Bill began restructuring his portfolio for an inflationary environment all the way back in March 2020, when the pandemic first started and the Federal Reserve announced its first round of quantitative easing.
“Once the fiscal response became clear, we were thinking we need to be cutting back our fixed-income exposure. We need to probably be increasing our exposure to real assets and digital gold,” Bill said. Bonds, of course, don’t fare well during inflation.
But that inflationary environment that Bill was prepared for didn’t come right away. Instead, the economy teetered on the brink of deflation in the second quarter of 2020, with average inflation coming out to approximately 0.3%, significantly below the Fed’s target of 2%.
Higher inflation numbers didn’t really start popping off until April 2021, when inflation hit 4.2%. From there, numbers just kept creeping up. For Bill, that’s meant that having an investment strategy with a significant inflation hedge is more important than ever.
“We’re trying to make sure that our portfolios are adjusted to sail through this environment,” said Bill. “We have 10% in traditional hard assets like physical real estate, and about 5% in diversified real assets like commodities, farmland, timber, and mineral rights.”
Bill has also shifted some of VTA’s portfolio out of fixed income and into other asset classes.
“The negative real yields are a big drag on returns,” he said. “That money has been shifted into private credit, hedge funds, and digital gold.”
Bill is optimistic about Bitcoin as an inflation hedge. The VTA is invested in the cryptocurrency, through its partnership with SkyBridge Capital, at an average entry point of $18,000.
“We view Bitcoin as potentially a digital gold portfolio,” Bill said.
Bill believes we will continue to see high inflation numbers for the next 18 months or so. He points to the disconnect between housing prices and owners’ equivalent rent as evidence that there is more inflation on the way. Owners’ equivalent rent data is measured using a federal survey that asks how much money the average homeowner would expect to pay if they were to rent their current residence instead.
“If you look at housing prices versus owners’ equivalent rent surveys, there’s a pretty big disconnect between the appreciation and housing, and what they’ve been collecting on the survey data,” said Bill. “So in the near term, I think there’s still more pent-up inflation in those numbers that has not yet hit the indexes.”
But still, Bill is not convinced that inflation is here to stay long term. In fact, in the long run, he believes all the debt the federal government has accumulated during the pandemic will actually create the opposite problem.
“Looking forward several years I am actually more fearful of a situation longer term where we end up in a disinflationary environment,” Bill said.
Bill believes the United States economy could enter a debt deleveraging cycle, similar to what Japan has seen over the past two decades. The debt and demographics data points in that direction, and the idea is quite popular in hedge funds circles, according to Bill.
Robin Diamonte, CIO, Raytheon Technologies: “Inflation rises, bond returns go down, but our liabilities go down, and our funded status stays the same. And that’s really what’s important to us.”
Robin Diamonte isn’t changing her long-term strategy because of inflation. As a liability-driven investor, she doesn’t feel that inflation is a big risk to the funded status of her plan.
“Inflation rises, bond returns go down, but our liabilities go down, and our funded status stays the same. And that’s really what’s important to us,” she said.
Raytheon Technologies has $115 billion worth of assets under management (AUM), meaning that market timing or short-term investment bets on inflation numbers aren’t really an option for the company.
“If you have a portfolio that’s over $50 billion and you want to put on an inflation hedge, you’re going to have to make really significant capital changes to that portfolio,” she said.
But that’s not to say Diamonte hasn’t made any changes to the portfolio to prepare for inflation.
“We are actually looking through our portfolio and talking to our managers and seeing if on the margin if they are positioning themselves for an inflationary environment,” she said.
This marginal strategy has been especially useful for Raytheon’s fixed-income managers.
“We allow our managers to have views on duration and spread duration,” Diamonte said. “A lot of our fixed-income managers have positioned their portfolio to be short duration relative to the benchmark, which is a way to bet on inflation.”
Some of Raytheon’s managers are also opportunistically selling tighter credit bonds with the expectation that inflation will continue to rise.
Raytheon’s strategic partners, Wellington Management Company and Neuberger Berman Group LLC, also both have inflation protection built into their portfolios, as do several of Raytheon’s hedge funds.
“What we’ve done is really took a look inside our portfolio to say, ‘Are there components that will hedge inflation enough for us that we don’t have to deviate from our long-term strategy?’” said Diamonte.
Raytheon’s overall long-term investment strategy includes many inflation-sensitive assets such as commodities and multifamily and industrial real estate. The portfolio also uses risk parity, which uses risk exposure as a tool for asset allocation. Raytheon also added an inflation-sensitive asset portfolio to its defined contribution (DC) plan 10 years ago.
“We thought that it was important to incorporate inflation-sensitive assets into our target-date funds as well as provide it as a standalone portfolio so that our employees can also hedge against inflation, if they wanted to in their savings plan,” said Diamonte.
Altogether, Diamonte feels that Raytheon’s investments are in a strong position to deal with inflation, even in the scenario that interest rates rise significantly.
“We have a really diversified growth assets strategy that will hold up,” she said. “So I’m not really extremely worried about a rise in interest rates. Not enough to deviate from my long-term strategy.”
But even though she’s not making any major changes to the portfolio, Diamonte still has some personal predictions about inflation. She thinks that while it won’t last forever, it will still last longer than most people anticipate.
“If you were to ask me a couple of months ago, I would have said inflation is here to stay for a couple of years,” she said. “But now it looks like the Fed will start to act more aggressively and take actions and is likely to be able to tame it.”
Mark Baumgartner, CIO, Carnegie Corporation: “Inflation is going to be a little higher and a little stickier.”
With nearly $5 billion in AUM, one might assume that the endowment at the Carnegie Corporation of New York would have more maneuverability to take advantage of short-term inflation strategies. But like Diamonte and Raytheon, Mark Baumgartner also believes Carnegie’s investment strategy already has enough built-in inflation protection, making those sorts of moves unnecessary.
“Inflation is a as a risk factor that is embedded in everything that we invest in,” said Baumgartner. “We think that the way that the portfolio’s positioned right now is accommodating of changes in inflation, so we’re not making any dramatic changes yet.”
But that’s not to say Baumgartner isn’t keeping an eye out for potential changes down the line.
“We’re cognizant of inflation, and we absolutely need to monitor it,” he said. “But we’ve always been doing that. So that’s why we don’t feel like we need to make any radical shifts right now.”
Baumgartner is primarily looking at the market to try and predict what will happen next. He thinks that looking at the forward pricing of inflation is the best guess for future inflation.
“I think that the current levels are justified by what is happening in terms of supply and demand,” he said.
Baumgartner believes increasing wages combined with supply chain shortages have created a gap between supply and demand that is causing inflation. However, he tends to believe this gap is a temporary one caused by the pandemic.
“The market tells us how consensus believes those forces will play out,” he said. “The market believes disinflationary forces are going to win in the short term. And so we’ll see inflation decline from these high levels.”
At the same time, however, Baumgartner says there’s an indication that even when inflation drops, it won’t return to the pre-pandemic level of 2% per year.
“My personal belief is that inflation is going to be a little higher and a little stickier,” he said.
Other Experts Weigh In: “Inflation numbers over the next 12 months are going to look a lot less threatening than they did over the last 12 months.”
Robert Barbera, a financial economist at Johns Hopkins University, doesn’t believe that inflation will persist, even in the short term.
“I think the odds that we have a big inflation problem that the Fed ignores for four or five years approaches zero,” he said.
One overlooked dynamic is that, before the current inflation, there was a spell where prices were negative. Barbera points to the deflationary period seen in April, May, and June of 2020.
“You actually had something that approximated deflation,” he said. “So some of the price increases we’re seeing now are simply catch-up for the fact that they went up hardly at all or went down during the crazy part of the pandemic.”
The average inflation of both 2020 and 2021 together is 4.2%, still higher than the Fed’s target but not unheard of in the past 15 years.
Barbera believes the biggest drivers of inflation right now are supply chain bottlenecks, which will easily be overcome in the coming months. He does not think government stimulus was a major contributor to inflation, and he backs this up by showing the significant role used cars played in this year’s CPI.
Inflation for 2021 shrinks down to 4.5% when excluding used cars, food, energy, and shelter, according to the Bureau of Labor Statistics.
“Inflation numbers over the next 12 months are going to look a lot less threatening than they did over the last 12 months,” he said. “It’s going to look more like two and a half over the next year.”
Instead, what Barbera thinks investors should be nervous about is interest rates.
“To me, the equity investor now has to come to terms with how the market will perform if interest rates are going up, irrespective of what happens to inflation,” he said.
However, not all experts feel this way. Katy Kaminski, chief research strategist at AlphaSimplex, who primarily analyzes quantitative data, said the trends she sees in her data point to something more long-lasting.
“We believe that once inflation has left the station it’s hard to slow it down,” she said. “Most people have not dealt with inflation in this market environment, so they have consistently underestimated its impact.”
She points to rising commodity prices as one of the biggest indicators that this inflation will be persistent.
“The massive trends that we’ve seen in the commodity markets, in particular, that’s been the biggest driver,” she said.
Barbera, on the other hand, said commodity markets are generally poor indicators of inflation since there have been multiple times over the past two decades when the raw industrial commodity index has spiked without causing any changes to inflation.
Kaminski acknowledged that commodities are just one piece of the inflation picture, but she still thinks the inflation shock brought about by the pandemic will continue to persist for a while.
“The fact that it’s moved so much means that the system has to adjust to it,” she said. “My view is that that’s not something that just stops. It takes time to kind of permeate through the system.”
She and her team at AlphaSimplex are expecting a longer timeline before inflation finally lowers.
“We think it will take at least a couple of months, if not one to two years, to calm down,” she said.
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