Inflation-mitigating portfolios have often proven costly during times of low or falling inflation. When so many commentators argue that an era of structurally low inflation is at hand, it is tempting to give up on trying to mitigate its potentially damaging effect.
We believe that is a risky position to adopt. The inflation regime of the 1970s and 1980s was very different from that of the 1990s and 2000s, and the inflation regime of the 2010s forward may be different again. Some current structural trends are inflationary and some are deflationary, and it is difficult to discern which will be the more powerful. Forecasting inflation has always been a challenge, and that challenge may be getting harder. It may pay to prepare for higher or more volatile inflation.
We show that building an inflation-mitigating portfolio that does not drag on returns when inflation is low or falling involves diversifying between assets that respond differently to different kinds of inflation, as well as exhibiting different risk-return characteristics. But we also believe that tactical allocation between those assets, and between a combination of real and traditional assets, can be beneficial as investors move between different economic environments. In addition, we show that inflation-mitigating portfolios need not be “one-size-fits-all”: we believe they should be tailored to the specific drivers of inflation to which the investor is exposed.
Executive Summary
- Forecasting inflation has always been difficult and prone to error.
- Some current structural trends are inflationary and some are deflationary, and it is difficult to discern which will be the more powerful over the coming years.
- We think this makes a strong case for preparing an inflation-mitigating allocation.
- Traditional approaches to this have often resulted in allocations that drag substantially on return during periods of low or falling inflation, particularly since the 1990s.
- Diversifying between asset classes that are sensitive to different inflation dynamics, and that offer different risk-return characteristics and different compositions of income and capital appreciation, can help to mitigate this opportunity cost.
- This diverse set of assets exhibits very different performance depending on which inflation-growth environment we are in:
- Rising inflation and rising growth
- Rising inflation and falling growth
- Falling inflation and rising growth
- Falling inflation and falling growth
- That helps to mitigate opportunity cost in itself, but it also suggests to us that tactical allocation, between different inflation-sensitive assets and between inflation-sensitive and traditional assets, in the form of a fully integrated portfolio, is a necessary corollary to diversification.
- In addition, we note the importance of building an inflation-mitigating portfolio that is tailored toward the specific drivers of inflation to which the investor is exposed.
- We show a case study of an inflation index tailored for a healthcare provider and the performance of a hypothetical portfolio tailored to mitigate the inflation tracked by that index.
- We conclude that there are three steps that investors should consider when they are building portfolios to withstand inflation risk:
- First, if possible they should be clear about what kind of inflation they are exposed to. What costs, expenses and liabilities do they have?
- Second, it is beneficial to diversify among assets that are being held to mitigate inflation risk. Each has its own risk-return characteristics and each responds differently to different kinds of inflation.
- Third, and for the same reason, it can be beneficial to allocate tactically to individual traditional and inflation-sensitive assets as we pass between the four different inflation-growth environments.
A Blended Portfolio of Traditional and Real Assets Could Be Tactically Adjusted to Different Inflation and Growth Regimes
Source: Neuberger Berman, Bloomberg. “Strong Growth” and “Weak Growth” are defined as a falling or rising rate of change of U.S. GDP with respect to the trend (i.e., the rate of change of the trend function is negative or positive). “Falling Inflation” and “Rising Inflation” are defined as a falling or rising rate of change of inflation with respect to the trend (i.e., the rate of change of the trend function is negative or positive). “Stable Inflation” is defined as a rate of change of the trend function that is close to zero. Returns shown are the average of the annualized returns recorded across all incidences of each regime, from January 1970 to December 2018. Indices used are shown in the note to figure 3. For illustrative purposes only. Past performance is no guarantee of future results.
