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Aon Retirement and Investment Blog

Big I, Little I or Something In Between

I’m reminded of so many things I take for granted when it comes to parenting. A few months ago, I worried that I would be the only parent with children who weren’t potty trained. Thankfully that worry is (mostly) behind me and who cares if going potty outside gets the job done. My neighbors maybe, but that’s why we have a fence, right? What has been top of mind of late is the alphabet. Letter recognition seems hard when taken across 52 letters (26 uppercase and 26 lower), not to mention the various types of font which make a “C” look like a “G”. When will my 4-year-old be able to distinguish a “W” from an “M” and understand the difference between uppercase (Big) “I” and lowercase (little) “i”?

Perhaps in letter recognition for myself I got to thinking about the market, and specifically inflation. What is the impact on our portfolios from big I (>3% inflation) and little i (0-2% inflation)? What are the best inflation hedges? And frankly, should I even care if inflation increases?

A little historical context:

The monetary decision-making body in the U.S. is the Federal Reserve (Fed). The Fed has dual mandates of full employment and price stability. Currently the Fed defines full employment somewhat loosely. However, key decision makers estimate a long-run normal rate of unemployment to be between 4-4.6%, with a median of 4.5%. At less than 4% unemployment currently, we can comfortably state we’re there. Inflation, or price stability, the Fed defines through the annual change in the core PCE index (excluding volatile food and energy) with a target of 2%. In the second quarter of 2018, annual inflation reached 2%, and has stayed around that threshold since. Prior to 2018, inflation, based on the Fed’s preferred measure, has been below its 2% target since May 2012 (~70 months)[1].


So, inflation is rising modestly, or at least where we want it to be.  What happens from here? In an ideal situation, the Fed, in conjunction with Congress (fiscal policy, e.g., stimulus from tax cuts), influences price stability by controlling the Fed Funds rate, or the rate that banks charge each other for short-term loans. As the Fed increases this rate, short-term lending becomes more expensive, reducing economic activity as households are less willing to buy goods and services, and businesses are less willing to expand their operations (employment and capital expenditures). The Fed has raised rates nine times since the end of 2006, which coincidentally, is the period when annual inflation in the U.S. reached 3.4% and when the Fed last stopped raising rates. 

But what happens if the Fed, in conjunction with fiscal stimulus, overshoots and inflation increases above 3%? It might be helpful to take a look at the last time inflation was above expectations. In August 1992, the core PCE index fell below 3.0%. Excluding the first three months of 1987, inflation had been above 3% since 1973 (nearly two decades!).  Using available market data (e.g., corporate yields began to be tracked by Barclays in 1987), the market would experience an increase in U.S. Corporate high yield bond yields from ~14% (1987) to a high of 20% (1990) and back down to 10% by the time inflation hit 3%. Some of this was rate, rather than spread, related as U.S. Treasury yields also rose from 8.4% in 1987 to a peak of 9.6% in 1989 before they bottomed in 1993. Over the same period equity markets would return an annualized 15% between the end of 1987 and 1993 as measured by the S&P 500 index.[2] The annualized returns mask significant volatility in equity and spread markets, owing in part to significant policy changes at the Fed, a financial crisis, and the Gulf War.

Okay, so inflation isn’t bad for markets? Well not exactly. Controlled inflation is actually quite healthy for markets as it has the effect of increasing borrowing costs (real yields + inflation = nominal yields) helping temper excessive leverage and promote wage growth, which ultimately should result in increased spending or saving. However high inflation or uncontrolled inflation, including periods such as the early 1980s, where core inflation reached 10%, and 1990, where it reached almost 5%, were both marked by recessionary economies, followed by a period of significant reduction in the Fed Funds rate. Stated differently, the Fed had raised short-term lending rates to double digit levels (1980s) to control inflation, which made everything from borrowing to lending challenging.

Do I care if inflation is increasing? Many pension funds in the U.S. are less exposed to unexpected inflation changes due to the lack of post retirement cost of living increase. Higher than expected inflation could actually reduce the real cost of unhedged pension obligations provided it was not coupled with low economic growth and equity. Nominal bonds, particularly long bonds, make excellent hedges to a pension’s long-term liabilities. For public/governmental plans, DC plan participants, and non-profits, particularly those indexed to a level of spending + inflation, inflation surprises matter. For DC plan sponsors, work force planning becomes a real problem if participants cannot retire because their retirement income adequacy is insufficient. For foundations and endowments, annual spending targets are often set off of a set threshold (e.g., 5% of trailing 12 quarters’ assets) plus inflation.

So, if moderate inflation is healthy for markets, what can I do to prepare my portfolio for higher inflationary environments? The good news is there are a number of ways in which asset pools can insulate against inflation headwinds, and some funds combine a variety of the components below for return and diversification benefits.

TIPS: One of the purest forms of inflation protection is through the use of Treasury Inflation Protected Securities (TIPS). TIPS are government issued securities whose principal is tied to an inflation index (in this case CPI). The instruments are “relatively” new, having been first introduced in 1997 by the U.S. Treasury Department. Inflation-linked bonds outside the U.S. (linkers) have been used since 1981. When inflation increases, the principal on these securities also increases, meaning more money at maturity. In addition, coupon payments are calculated off of the new, adjusted principal, every six months, benefitting investors during sustained rises in the price of goods. The opposite is true in deflationary scenarios where the principal is discounted by declines in CPI. It should be noted, however, that at maturity an investor is paid the greater of inflation-adjusted principal or par. TIPS are often incorporated in total return bond portfolios, both core and core plus. Standalone TIPS mandates are available in both a passive and active format and inflation-linked securities are also available in non-U.S. These markets are smaller than the U.S. so liquidity should be a consideration. For comparison purposes, the TIPS market is approximately 15% of the size of the Treasury market and nearly the same size as the U.S. High Yield market[3]. Despite direct advantages in adjusting to inflation, TIPS have a disadvantage of having relatively low expected returns, so they may not be suitable for investors with high return targets. 

Commodities: Commonly accessible to investors as baskets of goods or indices, commodities offer a more nuanced approach toward hedging inflation. An investor might buy livestock futures, timber futures, crude oil futures or even precious metals to counter inflationary pressures. The most common method of investing is through a basket of goods to help insulate from idiosyncratic risks (e.g., pine beetle infestation or forest fires for timber) and volatility. Investors should take care that all commodity indices are not created equally, and some attempt to equalize the weighting of goods underlying and others may weight based on world production or some other factor. Though the relationship between commodities and inflation can be attractive for those concerned about protecting against inflation risk in the first phase of an inflation spike, commodities historically have exhibited volatility unrelated to inflation and therefore are not a reliable hedge long-term.  This, combined with low expected returns, make commodities unattractive for many investors.

Real Assets: Real assets offer a number of potential advantages but some disadvantages in protecting against inflation. The advantages include a direct linkage between inflation and replacement cost, low correlation to other asset classes, particularly publicly traded assets, appreciation potential and both local and global implementation.  The disadvantages include liquidity, fees, capital requirements (if going direct) and valuation frequency. Of the primary market sectors in real estate investment, multi-family residential offers one of the most direct inflation hedges. As inflation increases, apartment rents are often among the first to rise, particularly if the labor market is tight and interest rates have begun to escalate making single-family home buying more expensive. Other real estate sectors offer varying degree of inflation hedges. For example, office leases may reset annually, but commonly 5+ year leases are made. Lease length can also act as a proxy for real asset duration. Timber, natural resources and farmland function as hybrid investments between real estate and commodities, exhibiting characteristics of both asset classes. They tend to offer diversification, stable income streams and if managed properly[4] can provide a reasonable hedge to inflation over the long-term. Underlying prices often are impacted by global supply and demand causing a less robust inflation hedge over the short-term.  Within infrastructure, lower risk “brownfield” projects may provide less of an inflation hedge particularly if the ability to increase fees is regulated. Newer “greenfield” projects bear risks associated with new construction and financing risk, but can exhibit higher pricing power (e.g., better inflation hedge) over the life of the project.

Less good hedges? Floating rate debt is an interesting, and increasingly liquid, market space that offers some hedge to inflation. As the Fed increases interest rates to stem inflationary pressures, floating rate debt interest rates increase even if no increase in spreads.  Why? Well the reference rate for most floating rate debt is a market rate (historically LIBOR or PRIME). As the base rate increases, so does the interest rate. The challenges to this market include the potential for spread compression or widening, which weakens the link to inflation, and if in the below investment grade segment, increases in debt servicing costs could place undue pressure on an issuer to either refinance or default. Equities have also been used as inflation hedges over longer-term periods, as corporate costs, revenues, and profits are expected to increase over time. Equities may be a poor hedge over shorter periods, as significant surprises, or shocks, in the rate of inflation (up or down) would likely drive equity values down.  Currency could also be used as a quasi-inflation hedge, however there are a variety of factors that influence currency other than inflation including balance of trade, legal and regulatory environment (e.g., tax incentives for repatriation of capital), changes in reserves, etc. An investment in cash could technically serve as an inflation hedge, albeit it is generally considered a poor one. Cash has the benefit of being a safe-haven asset during times of market stress, but cash will almost always be a lagging instrument as short-term rates are adjusted to help control economic growth. Finally, direct investment in commodity stocks can provide a form of inflation protection; however, many of these companies have hedging programs to help insulate their financials from price volatility muting the impact of the direct inflation hedge.

In Summary

Regardless of your asset pool, there can be a reason to buy inflation protection. Is now the right time? Well, that depends greatly on your organizational needs and time horizon. Our medium-term and market aware implementation can provide more tactical views on inflation hedging strategies but are intended to address broader themes impacting markets. Those investors with longer-term horizons can articulate an inflation hedge in a variety of ways but should be aware of the potential for increased illiquidity, governance, and fees associated with these types of investments. At the end of the day, perhaps it’s easiest to again think like a parent:  Implementing inflation protection is like a trip to the potty before a long car trip – your child may not have to go, but the cost of trying is dramatically less than the cost of cleaning up the mess.

Emily Hylton is an Associate Partner and investment consultant in Aon’s client service team in Atlanta. 

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“Content prepared for U.S. subscribers, but available to interested subscribers of other regions.”
 
[1] May 2012 – March 2018. Measures number of months in which seasonally adjusted annual core PCE Price Index is at or above 2%. The Price Index has been at or approximates 2% since March 2018 through September 2018. Source: Bureau of Economic Analysis, PCE excluding food and energy (DPCCRG), monthly. 

[2] PCE Source: Bureau of Economic Analysis, PCE excluding food and energy (DPCCRG), monthly, since inception. Market Indices Source: Bloomberg Barclays Indices yield to worst for U.S. Corporate High Yield, U.S. Treasuries and S&P 500 Total Return Index (Bloomberg ticker SPX-TR), quarterly since inception.

[3] Source: BarclaysLive. Bloomberg Barclays Indices as of 12/31/2018 – U.S. Corporate High Yield, U.S. TIPS and U.S. Treasury market values in USD.

[4] Unmanaged, or poorly managed, timber, natural resources and farmland can lead to depletion or stunted growth thereby capping the long-term income potential of the investment and eroding scale and pricing power.

The information contained above should be regarded as general information only. That is, your personal objectives, needs or financial situation were not taken into account when preparing this information. Accordingly, you should consider the appropriateness of acting on this information, particularly in the context of your own objectives, financial situation and needs. Nothing in this document should be treated as an authoritative statement of the law on any particular issue or specific case. Use of, or reliance upon any information in this post is at your sole discretion. It should not be construed as legal, tax or investment advice. Please consult with your independent professional for any such advice. The information contained within this blog is given as of the date indicated and does not intend to give information as of any other date. The delivery at any time shall not, under any circumstances, create any implication that there has been a change in the information since the date of publication, or any obligation to update or provide amendments after the original publication date. The blog content is intended for professional investors only.


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