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!
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).
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.
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).
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.
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.
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