Home / Inflation protection in the Christmas stocking

Inflation protection in the Christmas stocking

Kent Wilkes, Director, Fixed Interest and Inflation, QIC

The ‘Happy Season’ is not usually associated with bargains. Quite the opposite. Spending up is the norm and indulging is portrayed as a virtue. 

There are, however, investment bargains to be had for those willing to look beyond the headlines. Global inflation protection, for instance, is now on sale at bargain prices, according to our analysis. 

  • Talk of buying protection to guard portfolios against corrosion by inflation may seem out of step with the times while large parts of the world have been struggling with disinflaton in 2014.  

    Japan remains stuck in a two decades long deflationary funk and the US economy has been grappling with unusually low inflation. Moreover, low inflation expectations seem to be consolidating in Europe (Figure 1).

    Measures of long term inflation expectations are below the European Central Bank’s (ECB) 2 per cent target. It shows a remarkable lack of market confidence in policymakers’ ability to deliver on their 2 per cent inflation objective – hardly a huge figure – in 10 years!  

    Fig 1 Low Inflation

    Other dynamics have strengthened the forces of low inflation of late.  In November, the oil price fell to its lowest level in four years as OPEC announced that they would not cut production. While falling oil prices typically impact short-term headline inflation, longer term inflation expectations also fell sharply on the news. 

    It would seem that low global inflation is here to stay, end of story. That, however, would be a case of assuming that the future is a simple extrapolation of the present.  

    The inflation picture is, in our view, more complex than suggested by currently low inflation data.

    While the European and Japanese economies are lacklustre and US inflation also remains low at this time, the US economic engine is powering up. The pace of employment growth is upbeat and the falling unemployment rate, now below 6 per cent, suggests that capacity constraints, wage growth and pricing pressures will follow (Figure 2).

     Fig 2 Pricing Pressures

    We believe that data and actions pointing to how future inflation may unfold is not getting appropriate market attention, at this time. 

    Perhaps above all else, the US Federal Reserve’s (Fed) exit from unprecedented monetary policies is fraught with policy miscalculation risks. By the same token, the inflationary impacts of central bank policies to kick-start economies may not be known for some time. 

    Inflation hawks like Richard Fisher, President Reserve Bank of Dallas, have loudly voiced worry that the extraordinary stimulus provided is akin to tinder that can erupt into a bushfire. Ideas like his challenge the ‘there’s little to worry about in the inflation garden’ view. 

    Meanwhile, ECB head Mario Draghi announced at his December press conference that he would not tolerate persistently low inflation and would implement even more aggressive measures to lift inflation from its current lows. The ECB will add more assets to its balance sheet (Figure 3) to do so suggesting that a turning point in the fight against uncomfortably low inflation is nearer.  

    Fig 3 ECB Balance Sheet


    Buy direct, not indirect inflation protection

    Investors often utilise equities, property, infrastructure, commodities to hedge against inflationary risks. Each of these asset classes has their strengths but they also represent roundabout, rather than direct ways of achieving inflation protection.

    Equities, for example, are leveraged to company earnings and broad economic trends. They are not specifically designed to protect against inflation. 

    To protect against inflation, investors should buy inflation protection, we believe. No ifs, buts and qualifications.

    Inflation linked bonds (ILBs) have historically been a go-to asset for many investors wanting inflation protection. Right now they are a vulnerable asset class, in our view, as a stand-alone investment.

    The global hunt for yield means that many traditional fixed income assets, including ILBs, are already richly valued. Real yields are low and even negative in some instances (Figure 4)

    Fig 4 10yr Real Yields 

     It’s a situation that should cause investors to be cautious. Capital values will be eroded when bond yields move higher. 

    Investors can’t say they haven’t been warned. The Fed has already communicated that US interest rates will move higher. 


    Get explicit inflation protection 

    Rather than owning an asset that combines the undesirable yield vulnerabilities of ILBs as well as their desirable inflation protection attributes, we think investors should go for explicit inflation protection.

    This requires investing in exposures that isolate the market’s best estimate of expected inflation plus an inflation risk premium (known as Break-even Inflation – BEI) BEI pricing globally is currently very cheap (Figure 5) and offers a rare opportunity to buy cost-effective insurance/protection against inflationary impulses.  

     Fig 5 Break Even Inflation

    Not all inflation solutions actively manage the risks associated with ILBs. Those that do can protect against inflation as well as deliver potentially more consistent real returns.  

    We have long advocated a dynamic approach to inflation protection, which takes into account both expected and unexpected inflation outcomes not currently priced into asset values. This active approach employs strategies to isolate and manage inflation and interest rate exposures through the economic cycle, with the aim of delivering consistent real returns. 

    Timing is paramount. 

    Investors who wait until inflation begins to rise will have missed out on the current global bargains for inflation protection. With inflation protection at historically cheap levels, now is the time to protect portfolios against unpriced inflation risk.


    [1]  See speech by Richard W. Fisher, President Reserve bank of Dallas  Beer Goggles, Monetary Camels, the Eye of the Needle and the First Law of Holes to the National Association of Corporate Directors,· January 14, 2014


    Important Information

    For more information about QIC Limited ACN 130 539 123 (“QIC”), our approach, clients and regulatory framework, please refer to our website or contact us directly.

    To the extent permitted by law, QIC, its subsidiaries, associated entities, their directors, employees and representatives (the “QIC Parties”) disclaim all responsibility and liability for any loss or damage of any nature whatsoever which may be suffered by any person directly or indirectly through relying on the information contained in this commentary (the “Information”), whether that loss or damage is caused by any fault or negligence of the QIC Parties or otherwise.  A number of the statements are based on information and research published by others.  No QIC Party has confirmed, and QIC does not warrant, the accuracy or completeness of such statements.

    The Information includes statements and estimates in relation to future matters, many of which are based on subjective judgements or proprietary internal modelling.  No representation is made that such statements or estimates will prove correct.  The reader should be aware that the Information is predictive in character and may be affected by inaccurate assumptions and/or by known or unknown risks and uncertainties.  Forecast results may differ materially from results ultimately achieved.

    Copyright QIC Limited, Australia 2014.  All rights are reserved.  Do not copy, disseminate or use, except in accordance with the prior written consent of QIC.

    Print Article

    ‘So obviously should happen’: ISPT, IFM Investors mull merger

    Industry super fund owned IFM Investors and ISPT are exploring a merger at the request of their shareholders amidst a challenging outlook for commercial property.

    Lachlan Maddock | 2nd Jun 2023 | More
    Addressing Major Changes Relevant to Long-Term Responsible Investors

     As we settle into 2023, we believe long-term responsible investors focused on risk management and opportunity capture, must consider material changes impacting four areas: 

    John Streur | 1st Jun 2023 | More
    INSight #256 with Matt Christ from Ninety One

    Matt Christ from Ninety One shares insights with James Dunn from The Inside Network on whether investors should wait to get better certainty in regard to reporting, standards, and expectations for climate investing.

    Investor Strategy News | 1st Jun 2023 | More