Inflation has been so low for so long, it's barely a blip on anyone's radar. But after years of accommodative monetary policy, higher inflation might soon be a risk. With banks holding more than $2.4 trillion in excess reserves, there is a significant possibility of an increase in lending activity that could lead to higher inflation. When that happens, investors holding a high concentration of U.S. stocks and bonds will suffer as inflation erodes the real return on their assets and could cause the value of their holdings to plunge as market participants begin looking for a way out.
Whether inflation will rise enough to cause meaningful financial disruptions is unknown, but that's the point. By the time a hurricane makes landfall, nobody wants to sell you insurance. Once inflation arrives, it will be too late to prepare for it. Rather than wait, now is the time to develop a strategy to protect portfolios from an unwelcome inflationary episode.
Most investors rely on a mix of stocks and bonds to generate growth over time, and most have done well in recent years. But after the S&P 500 index rose 32.4% in 2013, investors should be wary of the stock market's elevated valuations and the potential for a significant decline in U.S. share prices.
At the same time, the income stream produced by a portfolio of high-quality fixed-income securities is extremely low, and future returns appear destined to fall below levels required by most investors. With even the riskiest credit instruments offering low single-digit yields, bonds not only will fail to deliver sufficient income, but also might prove to be anything but safe if inflation takes hold.
Investors seeking both inflation protection and safety must build portfolios with assets that have the potential to generate real growth without taking on excessive amounts of interest rate or equity market risk. A multiasset approach increases the probability of success because the circumstances surrounding an inflationary outbreak are unknown in advance.
Here are several types of assets we believe play an important role in a multiasset real return portfolio:
Inflation-linked bonds. Treasury inflation-protected securities protect the investor because the principal is linked to inflation. TIPS have traded with negative real yields in recent years, but now 10-year TIPS are priced to deliver a real return of approximately 50 basis points after inflation. While low in absolute terms, locking in a positive real return is appealing in an environment where even a small amount of unexpected inflation will cause fixed rate assets to produce negative real returns.
Floating-rate assets. Floating-rate securities provide protection from inflation because inflation is often closely correlated with their reference rate. Corporate bank loans, for example, are typically structured with a floating coupon over 3-month LIBOR. In addition, loans are the most senior asset in a corporation's capital structure and are typically secured by the corporation's assets, making them less likely to experience a loss than other credit instruments. Given their floating-rate structure, loans offer attractive income prospects with virtually zero interest rate and limited inflation risks.
Arbitrage strategies. Many types of arbitrage trades represent an attractive substitute for bonds, especially when interest rates are low. Because the returns earned by an arbitrageur reflect the reward for providing liquidity over a short horizon, these returns are positively correlated with short-term interest rates. As rates increase, so typically do the spreads earned from simultaneous purchase and sale of related securities, making arbitrage trades a compelling alternative to fixed-rate investments with inflation risks building and nominal yields near record lows.
Equities. Some equity sectors enable investors to guard against inflation if purchased at discounted prices. Utility shares, for example, generally provide investors with attractive income streams with far less inflation risk than long duration bonds. While inflation erodes real growth potential, regulated price increases allow dividend streams to increase along with inflation over time. Similarly, resource-oriented equities benefit from rising commodity prices and provide a natural inflation hedge. In order to limit the risk of loss, investors should be opportunistic, purchasing equities only at times when prices are low enough relative to fundamental value such that a sufficient safety margin is present.
It's often said that inflation is the product of too much money chasing too few goods. Even if only a small amount of the $2.4 trillion of excess reserves in the banking system creeps into the economy, the United States could experience an inflation rate well above market expectations.
Preventing this massive dose of monetary firepower from generating an inflationary hurricane will require two critical actions. First, policymakers will need to identify the precise moment when they need to raise interest rates, and by the right amount. Second, they must have the will to carry out inflation-fighting policies that may also curtail bank lending and economic growth.
While the risk of inflation doesn't appear imminent, policymakers at central banks around the world have little experience in unwinding their large balance sheets. That fact alone increases the possibility for a surprise uptick in inflation. The lack of experience with these policy tools itself is good reason for investors to act now and restructure their portfolios to include assets that will protect them from inflation – because once the hurricane winds are spotted, it will be too late.
Dorsey Farr is a partner at French Wolf & Farr, Atlanta, and portfolio manager of FWF Real Return Partners LP.
