At the moment, the item that tops the agenda for most of our clients is no big surprise: inflation, and what to do about it in portfolios.
A close second, however, is a topic worried over for the better part of a decade: how to diversify the downside risk in equity portfolios when core government bond yields are so low.
Inflation is usually a midcycle concern. Downside risk in equities tends to come up late in the cycle. But the first five months of 2021, which saw a surge in commodities and cyclical stocks with rising Treasury yields, felt distinctly early-cycle.
Confused? You’re not alone. This is a truly singular global recession and recovery, and it is making portfolio diversification both vital and challenging.
Roaring Twenties, or Back to the Late Teens?
Has the pandemic given us a super-shortened recession and recovery, taking us back to the seemingly endless secular stagnation dynamics we experienced in the years before 2020? Or are we entering an entirely new regime, with structurally higher and perhaps more volatile growth and inflation—a sort of high-tech Roaring Twenties?
We believe either scenario is plausible. That explains many investors’ focus on both downside risk and inflation.
The Roaring Twenties scenario has had the upper hand for much of this year, in financial markets, the jobs market and the economic data. Over recent days and weeks, however, market pricing and a trickle of disappointing economic data have fallen in line with the “peak growth,” back-to-the-late-teens scenario.
That makes the views of one of our recent webinar audiences, on investing for inflation, rather interesting.
This 100+ strong global audience was mostly in the back-to-the-late-teens camp. In a straw poll, two-thirds thought that current inflation would prove transitory and that no major central bank would lose control of prices.
At the same time, they gave up an hour to hear us talk about preparing portfolios for potentially persistent higher inflation. Sure enough, almost half said they had changed or are intending to change their portfolio positioning based on inflation expectations, while only 23% said they definitely had no such plans.
We think this tells us two things.
First, investors do not need to believe that structural high inflation is a given to start thinking about how to hedge it. The last five months have perhaps been a reminder that many portfolios lack inflation exposure, after a decade of stable prices and disappointing performance from inflation-sensitive assets.
Second, when they look for hedges, they are likely to seek out balanced exposures that don’t bet the farm on structural high inflation.
Asset Allocation Challenges
In a way, this is a variation on the challenge that asset allocators have long faced around hedging equity downside risk. Core government bonds traditionally do the job, but with yields so low, they are likely to deliver only modest performance should equities sell off, but substantial losses should the economy and equity markets continue to heat up.
For that challenge, we have long advocated nontraditional uncorrelated markets, such as insurance-linked strategies or China onshore bonds; uncorrelated strategies applied to traditional equity and bond markets; or option strategies that can benefit from higher equity market volatility.
For the inflation challenge, we would identify a number of asset classes, including commodities; real estate (including real estate securities, which offer the liquidity to rapidly reprice for changing inflation expectations); index-linked bonds such as Treasury Inflation Protected Securities (TIPS); senior loans; and value equities.
Inflation Exposure Versus Risk
Deploying these assets without betting the farm on inflation comes down to a balance between inflation exposure and risk.
Commodities and value equities are generally highly responsive to inflation, and particularly inflation surprises—41% of our webinar voters selected commodities and gold as the “best” inflation hedge. They also tend to be volatile and subject to a lot of potential downside should the economy cool down, however. Senior loans with floating rates generally offer reasonable inflation exposure with moderate risk, and the mix of real-asset exposure and regular income in real estate securities have generally made them effective in inflationary scenarios but resilient in slowdowns. One in five voters picked real estate as the best inflation hedge.
Traditionally, index-linked bonds would have a big role to play, with their high inflation sensitivity and low risk. They are still core government bonds, however, and their low yields and long duration might suggest a more cautious allocation today. Only 14% of voters selected them as the best hedge, smaller than the vote for equities.
Balance Is More Vital Than Ever
Overall, our conversations with clients and the views of our webinar audience bring home just how complex it is to maintain a genuinely balanced, diversified portfolio right now.
Economic and market uncertainty is high. The traditional cyclical signposts are not clearly marking the road ahead. The normal diversifiers, for both disinflationary and inflationary risks, are arguably too expensive to be useful. We believe investors need alternatives, and those alternatives need to be carefully diversified themselves, and allocations calibrated for their respective risk and volatility.
Most of all, we see investors becoming increasingly aware how easy it is to be caught with portfolios that are much less balanced than they appear to be—when balance is as vital as ever.
In Case You Missed It
- S&P Case-Shiller Home Price Index: March home prices increased 2.2% month-over-month and 13.3% year-over-year (NSA); +1.6% month-over-month (SA)
- U.S. Consumer Confidence: -0.3 to 117.2 in May
- U.S. New Home Sales: -5.9% to SAAR of 863,000 units in April
- U.S. Durable Goods Orders: -1.3% in April (excluding transportation, durable goods orders increased 1.0%)
- U.S. 1Q 2021 GDP (Second Preliminary): +6.4% annualized rate
- U.S. Initial Jobless Claims: +406,000 for the week ending May 22
- U.S. Personal Income and Outlays: Personal spending increased 0.5%, income decreased 13.1%, and the savings rate decreased to 14.9% in April
What to Watch For
- Tuesday, June 1:
- ISM Manufacturing Indexx
- Eurozone Consumer Price Index
- Thursday, June 3:
- ISM Non-Manufacturing Index
- U.S. Initial Jobless Claims
- Friday, June 4:
- U.S. Employment Report