The market is expecting 1.75% annualized inflation over the next 10 years. Is that too low?

In fact, 1.75% inflation for the 2020s would represent a near repeat of the 2010s (see chart), a decade in which the Fed fell short of its stated inflation targets. But considering the Fed’s willingness to let the economy “run hot” and make up for past shortfalls, this seems like an easy hurdle to overshoot. Investors who believe there is more upside than downside to inflation may be tempted to build out a real assets sleeve for their portfolio, particularly at a time when other major asset classes appear expensive relative to history.

WEBART143 0220 Allocating for Higher Inflation graph web
Source: Federal Reserve Economic Data; Economic Research Division, Federal Reserve Bank of St. Louis

Offsetting Factors
Unfortunately, market pricing can be wrong in either direction. And of course, it could also be correct. Technological innovation continues to present a powerful offsetting force for inflation. We live in an economy where automation, price transparency, and scalable digital business models support a high growth / low inflation backdrop. As a net exporter of oil, the US economy also has greater immunity to energy price shocks, a major historical inflation trigger. One of the most cited inflationary forces recently has been rising labor costs, but the flat Phillips curve suggests there is still slack in the job market, supporting additional growth in employment without major pressure on CPI.

If annualized inflation comes in between 1.0% and 3.0%, we might look back at the 2020s as a decade when portfolio inflation beta didn’t have much impact, and massively de-risking a portfolio meant missing out on long-term equity growth. That could be a very realistic possibility. Fortunately, there are a number of opportunities for adding some additional inflation exposure in a way that maintains baseline return expectations:

  • Add REITs to an equity portfolio. In the short term they may trade similarly, but longer term, the inflation exposure embedded in real estate securities should be differentiating.
  • Carve out a portion of the Treasury allocation for TIPS. TIPS are less liquid in a short-term market selloff and typically provide lower diversification than Treasuries, two things that you don’t want in your safety bucket. However, they should outperform Treasuries if the market underestimates CPI. An allocation to TIPS should be funded by an asset with fairly low risk, like Treasuries or global sovereign bonds, providing another option for relative value.
  • Within credit, consider bank loans to help protect against rising interest rates driven by higher inflation. More specifically, real estate debt can provide attractive yields with less concern that higher inflation has harmed the issuer’s creditworthiness.
  • Adjust a private markets pacing plan to include commitments to real estate and infrastructure.
The Opportunity Cost of De-risking
Consider one hypothetical investor who shifted 10% from US equities to long-only commodities at the start of 2012, while a second investor shifted 5% from US equities to REITs and 5% from Treasuries to TIPS.

Over the subsequent four years, the first investor’s portfolio was 15% lower than it would have been, equally attributed to the negative-returning commodity position and the opportunity cost of not owning as much equity. Meanwhile, the second investor gave up only about 1%, as REITs and TIPS nearly kept pace with US equities and Treasuries, respectively. Both investors improved portfolio positioning for an inflationary environment, but only the second investor’s portfolio kept pace with peers when that environment failed to materialize.

While some inflationary tailwinds have emerged, there are just as many headwinds. Assessing your portfolio’s exposure to higher inflation and making a proportionate asset allocation response might lead you to one or more of these modest portfolio tilts. The goal should be to improve performance in an inflationary environment without undermining long-term returns if it doesn’t quite play out.
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All investing involves risk, including the risk of loss. Investment risk exists with equity, fixed income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided.

This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed are as of February 2020 and may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted, and actual results may vary.

All asset allocation scenarios are for hypothetical purposes only and are not intended to represent a specific asset allocation strategy or recommend a particular allocation. Each investor’s situation is unique and asset allocation decisions should be based on an investor’s risk tolerance, time horizon and financial situation.