Inflation outlook: Assessing risks of inflation to long-term portfolios
Global Investment Insights
with Joe Kalish, Chief Global Macro Strategist, Ned Davis Research (NDR)
Joe is the Chief Global Macro Strategist at Ned Davis Research (NDR), responsible for all of NDR’s bond and economic analysis.
With signs of inflation emerging, fears are rising that we might be headed for a sustained bout of inflation. This is causing long-term capital allocators to reassess inflation risk in their portfolios and rethink their asset allocation.
Joe discusses his perspectives on inflation expectations, the key indicators he is tracking in monitoring inflation trends and shares his views on asset allocation under this uncertain outlook, in this exclusive interview with GII.
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Q. Inflation: Is it transitory or permanent?
A. The inflation surge in the US and elsewhere is largely transitory, but it could take longer to normalise than most economists thought just a few months ago, due to supply chain bottlenecks and capacity constraints.
Component shortages, particularly semiconductors, have hindered production. Port and shipping congestion, truck driver shortages, and reduced air freight capacity have driven up transportation costs. Some shipping indexes are continuing to hit new highs.
Extreme weather events do not appear to be subsiding. For example, the drought in western US is not ending anytime soon.
But, there is some light at the end of the tunnel. Prices of several commodities appear to have peaked, and supplier delivery indexes may have topped also.
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The inflation surge in the US and elsewhere is largely transitory, but it could take longer to normalise due to supply chain bottlenecks and capacity constraints.
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I am watching three things to see if the move in inflation is transitory or more permanent:
1. Inflation expectations - These are off their peaks reached earlier in the year in the US, but are trending higher in Europe.
2. Real estate - Shelter costs eased over the past year or so in the US. Now offices are reopening and rents are starting to firm. Additionally, surging house prices tend to lead rents by roughly 18 months.
3. Wages - if we are truly going to see permanently higher inflation then it should show up in wages and compensation. Despite a record number of job openings and anecdotal reports of higher compensation, such evidence has thus far failed to show up to any great degree in the broader measures of compensation. In fact, nonfarm unit labour costs were effectively unchanged over the past year. These costs tend to correlate well with core inflation.
Q. How does inflation affect different asset classes?
A. Historically, physical assets such as commodities and real estate have performed well during inflationary periods. This was especially true when it was commodities, such as oil, driving inflation. Gold and other precious metals soared during the 1970s but cratered when inflation subsided. Housing has kept its value in all types of pricing environments except following the subprime bust.
REITs have also done well in various pricing environments, as landlords have been able to raise rents to cover their costs. That assumption could be challenged today, especially in the Retail and Office sectors.
Stocks have performed better in disinflationary environments than during inflationary environments, generating negative real total returns in the 1970s and early 1980s. Sector performance was mixed, depending on whether the sector, industry, or company had pricing power.
Cash has also done remarkably well, performing comparable to stocks, as central banks raised rates to combat inflation and reduce inflation expectations. Cash, however, seems unlikely to keep up with inflation this cycle, as central banks remain accommodative to aid their recoveries.
Not surprisingly, bonds have not done well, as they have fixed coupons. They would do particularly poorly this cycle, given their low starting yields.
Q. What is driving inflation higher at the moment?
A. There are several items that have driven inflation higher, mostly on the goods side, due to product and component shortages.
In the 12 months ending July 2021, energy has played a big role in driving US inflation higher, rising 23.8%, compared with 5.4% for the Consumer Price Index.
Even by excluding the more volatile food and energy categories, core inflation has risen 4.3%. Transportation costs are playing an integral role. Used cars and trucks have led the surge, soaring 41.7%, down from a record 45.2% in June 2021. New vehicles have increased 6.4%, the most since January 1982. Car and truck rentals have skyrocketed 73.5%. Airfares have gone up by 19%, leading the public transportation category. Major appliances have climbed at double-digit rates. Sporting goods have advanced 5.7%. Tobacco has jumped 6.4%.
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In the 12 months ending July 2021, energy has played a big role in driving inflation higher, rising 23.8%, compared with 5.4% for the Consumer Price Index.
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The services side has been more subdued, rising 2.9%, excluding energy services. Here, there are a couple of standouts. Lodging has bounced 21.5% from last year’s depressed levels. Moving and storage have climbed over 13%.
Some alternative measures, which remove the outliers, show a mixed picture. Whereas the median CPI was range-bound at 2.3%, the trimmed-mean had risen to 3.0%, the most since October 2008.
Q. What impact are structural trends such as technology, ageing demographics (and others) having on long-term inflation-deflation trends?
A. I think they are having a tremendous impact on keeping inflationary pressures from getting out of hand. Technology and the pace of innovation has not slowed. In fact, lockdowns have accelerated the adoption of new technologies.
Globalisation and competition are here to stay. Although trade with China cooled in 2019 and 2020, it picked up with the rest of the world. Some production has shifted to the next lowest cost producer. Additionally, the world is moving more toward regional supply chains such as North America, Europe, and Asia. This reduces the risk of single-source suppliers.
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The world is moving more toward regional supply chains. This reduces the risk of single-source suppliers.
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Aging demographics have shifted consumption and borrowing away from goods and more toward services and saving.
High debt levels tend to be disinflationary, as the debt needs to be serviced. Credit growth remains soft. In order to have persistent inflation, credit growth needs to be sustained.
Finally, well-anchored inflation expectations have helped secure low inflation. In the 1960s and 1970s, inflation expectations were not well-anchored. That is why there has been a big emphasis on this among the major central banks.
Q. How should long-term capital be invested and what portfolio changes should institutional investors consider making to manage the effects of inflation?
A. Inflation has been a very strong determinant of how investors should position long-term portfolios. We are expecting inflation to be around the central banks’ targets, perhaps a little higher. Given low yields on bonds and cash, it will be challenging at best, if not impossible, to achieve return objectives with a traditional allocation such as 60% stocks and 40% bonds. That mix won’t get it done.
Under this scenario, equities should continue to do well and deserve an overweight allocation, say 65% or 70%. Bonds should have an underweight allocation, say 20% and include allocations to private credit. Cash should have a minimal allocation.
I would also advocate having some allocation to commodities, considering their poor performance over the past ten years and the lack of investment that has generally gone into commodities over that time. It should also provide a reasonable hedge against inflation in case inflation expectations turn out to be wrong.
Investors should also consider allocations to real assets such as infrastructure, residential real estate, and select areas of commercial real estate and REITs.
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Given low yields on bonds and cash, it will be challenging at best, if not impossible, to achieve return objectives with a traditional 60-40 stocks-bonds allocation.
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Contact Mark Trevena at mark.trevena@ndr.bcaresearch.com if you would like to know more about Ned Davis Research.
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