Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
PIMCO’s advice on inflation
PIMCO, the world’s largest fixed income manager, believes that there is more risk in the current inflation bogey than the market is anticipating.
It has published what is likely the most authoritative look at the current inflation concerns and suggested what investors should be doing about them.
The PIMCO paper, ‘Assessing Inflation: Theories, Policies and Portfolios‘, was authored by Josh Davis, global head of client analytics, Jamil Baz, head of client solutions and analytics, Peder Beck-Friis, portfolio manager, and quant research analysts Jerry Tsai and Ziqi Zhang.
Davis (pictured above) will be speaking on the topic at this week’s JANA virtual conference in Australia (starting September 14), which will likely present attendees with an easier insight into the manager’s thinking than by digesting the 35-page paper.
The authors say that PIMCO believes there are “fatter inflation tails than the market has expected”. Nevertheless, the paper says, longer term there is a high probability that inflation will be contained.
The manager therefore advocates investors take a portfolio approach to hedge against inflation risk, preferably taking account of a variety of macro scenarios over a five-10-year period.
“Salient positions are a private debt overweight and a public equity underweight,” PIMCO suggests.
The paper takes both an historical and quantitative view of inflation, including the history of fiscal and monetary theory as well as practice, looking for clues for investors.
With so-called Modern Monetary Theory (MMT, of which PIMCO is clearly not a fan), the only role for monetary policy is to keep interest rates at zero, continually financing government deficits.
“Many of these prescriptions are political in nature. We leave readers to form their own view. But we note that MMT stands out in its lack of rigor, and it leaves many questions unanswered,” the paper says.
“When does government spending run into the inflationary constraint? Where is full employment? MMT supporters argue that if fiscal spending overheats the economy, the government can quickly tighten the fiscal belt to bring inflation under control. History offers few such examples, however.
“High inflation has tended to feed on itself, especially when inflation expectations have de-anchored following passive monetary policies. The 1970s offer valuable lessons in this regard.”
In its assessment of asset classes which will perform relatively well or less well in an inflationary environment, the study looks at shorter-term versus long-term inflation. Equities, commodities, TIPS (inflation-linked bonds) and REITs all provide inflation-hedging benefits due to correlations with inflation, whereas nominal bonds provide no such benefit.
The paper then points out that different assets respond differently to the two different time horizons. Equities, TIPS and REITs respond more to short-term inflation, nominal bonds respond more to longer-term inflation and commodities co-move positively with both short and long-term inflation shocks.
