Commentary: Assessing inflation's many variables

When the consumer price index surged by 5.4% in June — its biggest jump in 13 years — Federal Reserve Chairman Jerome Powell told lawmakers he still believes prices are being "temporarily boosted by base effects." In fact, as part of his semiannual monetary policy report to Congress, he added that while he anticipates inflationary measures will likely remain elevated in the coming months, prices should moderate as supply constraints and COVID-19-related bottlenecks begin to unwind.

The prevailing question among asset owners — investors who haven't had to think about inflation for over a decade — is what this might mean for their existing portfolios and what strategic adjustments, if any, should they consider to guard against the threat of runaway inflation.

The challenge, of course, is that inflation is notoriously difficult to forecast. And whether investors plan for upside or downside scenarios, or even a base case of no change, can have a significant impact on performance or the effectiveness of specific hedging strategies. Many, for instance, took pains coming out of the global financial crisis to position their holdings for inflationary pressures that never materialized. This prolonged stretch could be likened to "Waiting for Godot," and probably felt even longer at the time as equities recouped significant losses. Hindsight being 20/20, asset owners realized that by overcompensating for what turned out to be a transitory impact, they ended up creating a new risk in the process.

While intent on not repeating past mistakes, institutional investors are today bracing for a potential inflationary impact. This is easier said than done. As it relates to any prospective hedges, investors must factor in not just the direction of inflationary measures but also the sources of price increases, the level and length of the inflationary period, whether or not it was anticipated, and the coincident level of economic growth. Policy responses from central banks represent yet another variable as would any additional stimulus. In fact, each of these developments could influence which asset classes may or may not be appropriate, but it depends on the specific combination of the aforementioned factors.

Both publicly traded equities and bonds tend to suffer when inflation increases, whether it's expected or not. This wouldn't come as a surprise to any seasoned investor. However, unexpected and persistent inflation is far more difficult to incorporate into portfolio construction. This makes scenario analysis critical to any prospective allocation adjustment, particularly as it relates to unexpected inflation, the influence of economic growth and the length of the inflationary cycle.

For instance, the difference between expected and unexpected inflation can be profound. Investible assets with a positive correlation to inflation such as gold, commodities — and to a lesser extent, publicly held natural resources — have far more sensitivity to surprise inflation than well-anticipated price increases.

Alternatively, U.S., global and emerging market equities, long-term government bonds and real estate investment trusts each exhibit pronounced negative sensitivities to inflationary surprises.

Still, inflation, expected or not, doesn't occur in a vacuum.

If inflation is accompanied by either robust economic growth or low-growth periods, the correlations — both positive and negative — can diverge wildly. High-growth environments, in which inflationary increases are not uncommon, tend to mute the negative correlations between rising prices and public equities and bonds. And gold, against the conventional wisdom, also tends to perform quite poorly during rapid economic growth, even if inflation increases. Treasury-inflation protected securities, on the other hand, stay relatively flat. In this scenario, though, returns from commodities are amplified when high inflation is paired with high growth.

In low-growth environments, equities and bonds historically have had negative correlations to unexpected inflation increases. Commodities, though, emerge as the best hedge in moderate- to high-inflation periods when the economy slows.

While most economists believe the recent spikes in inflationary measures are transitory in nature, should price increases drag on over a longer period of time, the duration of the inflationary period will influence the effectiveness of specific hedges.

This is generally true even in moderate inflationary periods. Over time, for instance, the length of the inflationary cycle will increasingly eat away at equity returns. And long-term government bonds don't offer much in the way of protection either, although annualized losses tend to be confined to a narrower range, whether inflationary spikes are either very brief or extend over a medium- or long-term horizon.

During extreme inflationary periods, similar tendencies play out. However, gold stands out as by far the most effective hedge in this scenario, showing a positive correlation to both the level and length of the inflationary cycle. Commodities, alternatively, still represent an attractive hedge. Amid runaway inflation, however, returns historically shrink as the duration of the cycle becomes more protracted. When inflationary spikes aren't as pronounced, though, commodities generally offer the highest returns over extended inflationary periods, and by and large provide a very strong hedge over any time horizon.

Other factors will not only influence these variables but also help to shape how specific asset classes may behave — not the least of which is monetary policy.

Mr. Powell has largely preached patience since inflation measures started climbing. St. Louis Fed President and CEO James Bullard, however, has been emphasizing the need for "optionality" to react in the event that pricing pressures are more persistent than previous expectations.

Another consideration is that certain asset classes, such as private debt, don't even have a track record that extends far enough back to offer a true picture of how the category will behave in an extended high-inflationary environment. On the other hand, across many institutional portfolios, what may have been a common 5% exposure to commodities 15 years ago has since been winnowed down to a non-existent allocation today. This means CIOs may have to start from scratch to incorporate these exposures into their portfolios.

Not to be overlooked, the prevailing drivers of inflation, themselves, are also evolving. Take wages: Compensation figures historically rise in accordance with economic growth. But this has not been the case for most of the last two decades as wage growth has lagged behind economic growth.

Given these and other moving pieces, there is no simple answer to predict how inflation will ultimately unfold. The consensus as of early August holds that rising prices will likely subside in the near term as economies reopen. We have seen some evidence of this potential in the recent core CPI for July, which came in slightly below expectations. This assumes, of course, the delta variant of the COVID-19 virus doesn't trigger renewed global lockdowns. However, understanding inflation's effect on different asset classes can help investors develop a portfolio positioned to hedge against the risk of rising prices or, at least, react appropriately as the specific nature of the risks come into view.

Frank Benham is a Boston-based managing principal and director of research, Alison Adams is a Portland, Ore.-based senior vice president and research consultant and Stella Mach is a Boston-based assistant vice president and senior quantitative research analyst at Meketa Investment Group. This content represents the views of the authors. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.