Inflation protection — better to be safe, not sorry

Sometimes it takes a crisis to make us all realize that, yes, inflation can always be lurking just over the horizon.

We certainly can't depend on how the markets have responded to economic signals about the potential for the coming onset of inflationary clouds. Just a short while ago, when many indicators across G-7 economies would have indicated that policy should be tightening to head off inflation, the markets uttered a resounding “meh” to the prospect. Then came a new crisis in Iraq, which only followed on the heels of the crisis in the Ukraine, all preceded by the never-ending crisis in Syria, which is now possibly merging with the crisis in Iraq, and so on.

What we're looking at is a classic non-consensual picture: the vivid contrast between reaction to economic signals and the prospects for inflation as driven by crisis. For investors, that's an opportunity. The case could be made that this is the best time to take out “insurance” against inflation through real-return strategies, in fixed income and elsewhere. The strong market-implied consensus for very low inflation makes such insurance inexpensive. For investors looking to reduce risk after the runup of equities in their portfolios, considering such inflation insurance could well be an attractive proposition.

The threats to the world are real. Iraqi oil is exported globally. Europe in particular is highly dependent upon gas at least supplied through Ukraine. The recent Sino-Russian oil deal gives protection to Russia's energy revenues and makes it less dependent upon the West, which is struggling to impose meaningful sanctions upon Russia. In previous crises in energy-producing countries, a spike in oil prices and a rise in inflation expectations would be de rigueur, yet there is little sign of this in 2014. Of course, the increased level of energy production in the US due to the shale gas boom is lessening the effects of such geo-political instability on the oil price.

From a macroeconomic perspective, the U.S. economy is growing steadily and unemployment has fallen more quickly than most had expected. The same can be said in the U.K., possibly even more so. Europe remains a drag, with structural inefficiencies left from the as yet not finally resolved euro crisis, but Germany, the main powerhouse, is still growing healthily.

Inflation has clearly not arrived yet. While this is unsurprising in Europe, the U.S. has also followed this trend. The chart below shows the year-on-year rise in the U.S. consumer price index along with a "surprise index"which rises by one every time inflation is higher than market expectations, and drops by one when it is lower. We can see a precipitous fall in the surprise index through 2012-'13, along with a declining inflation rate.

Also shown is the price of a five year deflation floor. This is a derivative instrument that compensates the buyer if the price level falls in any of its five years of life. As inflation has fallen, and fallen more sharply than expectations and to very low levels, one would surely expect the price of deflation insurance to rise. Yet as can be seen, the price of such protection is at a five-year low. Deflation insurance is cheap.

On the other side of the equation though, the price of the opposite instrument, the inflation cap, is also at historically low levels. Hence the markets imply a very strong consensus that inflation will be positive, but low. Options traders would recognize this as an opportunity to buy volatility, or “buy the straddle.” This pattern is similar across the major economies, with a high degree of conviction displayed by the market in a low-inflation volatility environment.

If we could break out of that low volatility, which way would it go? We know that governments and central banks have learned to be more sensitive to deflation than inflation in the post-crisis world, so all the major authorities, even the sometimes recalcitrant European Central Bank, could be relied upon to throw the kitchen sink at markets to prevent deflation from becoming entrenched. Maybe then it is the other side, higher inflation, that we should be worried about.

To see an increase in inflation caused by cyclical factors would require a concerted and sustained move higher in wage growth, which would be a good sign that the level of slack in economies was dangerously low. This seems a way off for now, but we should remember that policy is still set at emergency levels, with the Federal Reserve still enacting quantitative easing (albeit less now). We are a long way from the sort of policy settings that would restrain an unhealthy move in real wages.

The other route might be through a non-cyclical, exogenous shock, possibly caused by a geopolitical meltdown. A scenario where the Syrian crisis becomes contagious through the Middle East, or Russian tanks get uncomfortably close to the borders of the Baltic states, would surely lead to a spike in oil and gas prices. Yet this might not lead to much more than a one-off shift in the price level, rather than self-feeding inflation. Such a move might simply have a restraining effect on economic growth.

Of course, there is also the convergence of factors that could approximate a “perfect storm.” If a spike in commodity prices, precipitated by conflict, coincided with a cyclical move higher in wage growth, and thus a rise in the pricing power of labor, this could lead to a worrying increase in inflation.

How should investors respond to this? In an uncertain but generally positive world, a diversified portfolio of real assets looks attractive, and would include equity and real estate, for example. It would also include direct inflation protection through inflation-linked bonds, which would protect investors particularly if inflation was growth negative. The mix of those assets would depend upon the return aspiration and risk tolerance of the investor, but if we believe that we are entering a more inflationary world, then real assets are the place to be.

The markets are supremely relaxed over inflation, and probably rightly so, for now. Slack remains in economies, and there are enough areas of weakness to restrain price growth. It is likely that they are right to be, for a while, but when insurance for a non-consensual outcome is cheap, it might be as well to be safe, and not sorry.

Jonathan Gibbs is head of real returns at Standard Life Investments.