Over the longer term, the outlook is less clear. One important factor here is productivity. We have seen, [during] COVID-19, a lot of [operational] improvements by companies as well as an increase in productivity. This started pre-pandemic and has widened post-pandemic. To the extent that it continues, it could actually act as a catalyst for disinflation over the longer term.
NELSON: Short-term, over the next year or two, inflation is likely to be elevated with supply-chain disruptions and energy volatility likely to be the big influencers.
Over the medium term, stickier inflation items are potentially pushing inflation to 3% or higher. Some of these inputs include shelter costs and some components of services.
Longer term, five-plus years out, there are substantive deflationary forces that will help manage inflation expectations. These include everything from demographics to technology changes and automation, to higher productivity levels.
CHILDERS: To give the transitory [believers] their due, there is a strong element of current inflationary pressures that are correctly attributed to supply bottlenecks and other areas that the Fed and a number of other central banks are pointing toward. But if you look at the five-year forward break-even inflation expectations across inflation-protected bond markets, they’re really only back in the neighborhood of where they were in 2018.
In the long-term, that forward view is likely to be too low. The drivers have to do with the regime shifts that are taking place in terms of populist movements and ongoing fiscal and monetary stimulus pressures. How unit labor costs unfold from here will be a key metric to watch. If we see more of a sustained acceleration in wages without a commensurate pickup in productivity, then the market will need to reprice its expectations around not just near-term, but [also] medium- and long-term inflation.
P&I: How does the Fed’s intentions on asset tapering impact the inflation outlook?
NELSON: In a direct fashion, very little. Where it does have an impact is as a signaling function. The speed with which the Fed tapers balance sheet purchases will be a signal in terms of how concerned they are with current inflation conditions. The tapering speed then brings on the question, When do interest rates start rising? If the Fed moves faster than the market expects in terms of raising rates over the next two or three years, rising real interest rates will impact the inflationary outlook.
CHILDERS: Tapering has already been well digested by the market and is unlikely to move the needle much one way or another. If the schedule around tapering were to change, that could be a signal for a move forward or a move later in actual rate hikes.
STEINBACH: The Fed is going to take a multistep process in removing accommodation. The first step was talking about tapering. That was the headline this summer, and we’ve gotten past that with the Fed’s [Nov. 3] announcement that it will begin tapering its asset purchases.
Asset tapering is important, and it impacts the inflation outlook in terms of the timing of future Fed rate hikes. If the Fed perceives inflation as being problematic, it will likely speed up tapering in order to pull forward interest rate hikes. We’ve heard from the Fed in past speeches that its preferred sequence is to taper and then pause asset purchases altogether, reassess where we are in the economy and then hike rates. That’s the preferred playbook. What we heard from the Fed [in November] is that it is going to remain flexible, but it sounded like there was a fairly high bar to speeding up tapering.
If the market perceives that the Fed is speeding up tapering, moving to hike rates sooner and acting aggressively to stamp out inflation, then we could see a [market reaction]. The Fed doesn’t actually have to change its stance. It’s the market’s perception of what the Fed is going to do [that can cause] pretty severe market reactions. We saw that [in late October, when] inflation expectations, in terms of Treasury Inflation-Protected Securities breakevens, narrowed significantly in response to the idea that rate hikes may be getting pulled forward.
P&I: What are the investment implications of your outlook? Which asset classes/strategies are garnering the most attention and inflows today?
CHILDERS: For investors with liabilities that will be impacted by inflation, it’s worth paying attention to the inflation environment and turning one’s gaze toward the types of assets that are correlated with changes in inflation. History tells us that a lot of core assets, such as broad equity exposure and fixed income, often deliver below-average returns when inflation is accelerating, especially when growth isn’t [also] booming.
At the low end of the risk spectrum, from an inflation-hedge perspective, TIPS are fantastic. However, most investors are putting duration in their TIPS portfolios, which can be a potential complication if real interest rates are picking up—especially when starting real yields are deeply negative.
For investors looking for more return, the broad market has a time horizon issue. If you can say, I have the flexibility to rely on the equity risk premium even if I go through a rocky inflation environment over the next decade or so, then perhaps exposure to equities is OK. But if you’re worried about the headwinds that tend to push against equities when inflation is on the high side, then you should probably be looking at real assets. These can be boiled down to four core categories: real estate, commodities, infrastructure and natural resource equities. These are assets that have, historically, tended to experience above-average returns when inflation surprises on the upside; these are assets that carry more favorable sensitivities or inflation betas.
NELSON: For corporate defined benefit plans, a rising inflation outlook is likely beneficial to funded status. Should inflation stay high, interest rates eventually will move up, which will benefit the funded status of most plans.
Over the last 10 years, we’ve seen a steady decline of real asset or inflation-sensitive exposures in most portfolios. The primary source of that outflow has been in the commodity sector and commodity futures. On the margin today, we’re seeing inflows, but that’s probably more from tactical investors and it’s not [a move] that we’re encouraging [because of] structural risks in the commodity space.
In the defined contribution area, there are two key pieces. One is that most investors [within DC plans] are positioned with equity exposure. History shows that an above-average inflation outlook is generally constructive for equities over the long term. The second piece is for investors who are in the later stages of their careers or the back end of a target-date fund glidepath. In their case, asset classes like TIPS become an increasingly dominant exposure to provide inflation sensitivity in the portfolio.
STEINBACH: One might think that in a persistent inflationary environment, interest rates are going to rise significantly. While they will rise, it’ll be fairly gradual and probably not to the degree that some are expecting. There are significant pockets of demand that will keep interest rates low for the foreseeable future. Pension funds are wanting to immunize their liabilities, and so we are seeing increased demand for long-duration assets. We’re keeping this in mind as we invest and construct portfolios.
Over longer periods of time, equities can be a good hedge for inflation, assuming that companies are able to pass through price increases — either from input costs or higher labor costs — to consumers. But for near-term unexpected inflation, TIPS are the most effective way to protect a portfolio.
P&I: Are there new considerations in this inflationary cycle for fixed-income portfolios?
NELSON: In the prior decade, inflation averaged under 2%. A shift to an environment where inflation is closer to 3% over the long term is a risk that investors haven’t had to consider recently. In a fixed-income portfolio, that means more volatility in interest rates, and potentially a greater allocation to TIPS to provide inflation exposure.
STEINBACH: There’s rising concern around the ability of bonds to act as an effective diversifier from equities. Our analysis has shown, based on our inflation outlook, [that] bonds can continue to provide diversification versus equities, unless inflation breaks out significantly to the upside. For that correlation to really break down, inflation would have to be in the mid- to high single digits over a longer period.
Bonds continue to play an important role for diversification, and we don’t expect the benefits of bonds as an effective diversifier to change.
P&I: What about real assets as an appropriate diversifier and inflationary hedge today?
CHILDERS: We should be clear on what we’re talking about: real estate, commodities, resource equities and infrastructure capture the bulk of the real asset universe. The takeaway that long-term investors should understand is that the risk premia of a well-diversified portfolio of these assets over longer-term cycles is similar to that of a global equity portfolio.
The main distinction is when the real asset categories tend to earn payoffs that are above and below average. If you can invest in a portfolio of real assets that have equity-like long-term returns but pay off in different states of the world in terms of the inflation regimes, for example, that brings a diversification benefit. The effect is to increase risk-adjusted returns and bring up the portfolio’s inflation-sensitivity, creating a better balance across lower- versus higher-inflation regimes.
NELSON: Depending on how you define real assets, they are an appropriate diversifier and can provide inflation sensitivity with TIPS being the most important asset class.
Gold is a good place to be if there are concerns about the U.S. dollar. But if we’re in an above-average inflationary environment and there aren’t any concerns about the U.S. dollar, gold may not perform as desired as gold is not a pure inflation hedge.
Investors should ask themselves: What is the goal of real assets? Is it to provide a sensitivity to inflation over the long term or is it to provide protection from an inflation shock, such as oil prices moving up by 50%? For most investors, the key risk is inflation sensitivity over a longer-term period. As long as inflation is running above average, as opposed to high, equities offer one of the simplest and best exposures to inflation.
P&I: What is your perspective on real estate exposure, via listed markets or private?
NELSON: There are often two different return drivers that influence public versus private real estate. In public real estate, the equity risk premium is a dominant factor. In private real estate, the focus is different. What is the leverage level of the property? What is its operational focus? What is its top-line revenue growth? Then you need to consider which specialized real estate sectors may be more inflation-sensitive than others. Multifamily housing may have a much higher inflation-sensitivity profile than other areas of private real estate.
Our preference in real assets, broadly and within the sector, is to implement in private markets as opposed to public. Private markets are a more direct way to access both inflation sensitivity and strong underlying exposures.
CHILDERS: Real estate should be at the core of any real asset portfolio. In our own multi-strategy real-asset portfolios, we take a barbell approach. The two largest weights are real estate and commodities, with the middle filled out with infrastructure and resource equities. Real estate plays a key role in helping deliver on long-term return expectations and also in providing diversification and inflation sensitivity.
Ultimately, our research has indicated that whether real estate is private or listed, you get similar effects across the dimensions of inflation sensitivity, return and diversification. What matters is the economics of the real estate, more than the ownership vehicle per se. To motivate that intuition, the cash flows for this building that I’m sitting in, for example, are not significantly different whether it’s owned by a public or private entity.
P&I: Do you have target recommendations for inflation-protection allocations within a total portfolio? Should it be a separate bucket?
STEINBACH: As I mentioned earlier, TIPS provide the most explicit protection against inflation. When we construct retirement portfolios, we consider a dedicated allocation to TIPS between 2% and 7%. Thinking about a glidepath for our target-date solution, we introduce that explicit inflation protection shortly before retirement, and we increase it as the participant goes through retirement.
CHILDERS: Different investors think about this differently. Some investors have an inflation-protection bucket within their portfolio. Often this bucket has an array of liquid, listed real asset exposure as well as private real asset opportunities. Other investors might include real assets as part of an alternatives allocation. Whichever framework they use, the aim is to include real assets in the portfolio.
For our DC clients in particular, we want to be careful about the potential for bad behavior by DC participants in terms of responding to short-term volatility in unproductive ways. We advocate that plan sponsors consider the whole universe of real assets; not just real estate or TIPS, but also resource equities and infrastructure and so forth. All real assets share in common a sensitivity to inflation dynamics but also have a lot of non-inflation related drivers of risk and return that enable you to build diversified, better-behaved portfolios. By extension, this should lead to better-behaved plan participants as you are smoothing the ride in terms of reducing volatility.
NELSON: We generally encourage a distinct target allocation be used when allocating to real assets. The rationale is that the need for inflation protection is investor specific and may depend on your liability structure or your demographic profile. Some investors in the corporate DB space have minimal exposure to inflation-sensitivity as a risk factor and the need for inflation protection actually could be zero. While for a DC investor with a 40-year time horizon, the risk of inflation in the next 40 years is something to be considerate of and having a dedicated exposure over the glidepath is important.
Furthermore, TIPS are a strategic investment that is prudent for plan sponsors to include within the context of a target-date fund. The risk associated with commodity investments — or other kinds of pure exposure to real assets — is one that should be carefully considered by plan sponsors before implementation for a wide range of reasons, the most important being volatility.
P&I: What does the future hold in how asset owners think about inflation and how they might respond to inflation risks?
STEINBACH: Inflation will likely remain persistent but normalize in the next few years. It’s going to remain higher than the Fed’s target and is likely to put it in a fairly uncomfortable position next year, but we’re not expecting double-digit inflation or something like what we saw in the ’70s. It’s a very different environment. We’re expecting a modestly higher level of inflation, with bonds remaining a diversifier to equities.
NELSON: The most important takeaway when thinking about inflation protection is there is no simple solution to it.
Within the corporate DB space, we [anticipate] more of a total-return mindset as opposed to dedicated inflation protection. Private investments in infrastructure that have some inflation sensitivity are likely to increase. But the rationale for adding private real assets to a portfolio is more total-return focused, as opposed to providing inflation protection. Private debt falls under that same category: It has more of a total-return focus but brings some inflation sensitivity that’s beneficial.
CHILDERS: In the U.S., prior to 2021, we had 11 straight calendar years where realized inflation came in below what was expected 12 months earlier. We’ve had this highly unusual disinflationary environment. As you would expect of assets that tend to outperform when inflation surprises to the upside, you see an opposite effect when you get downside surprises, and a lot of real assets lagged in terms of their performance versus broader markets.
That has opened a large valuation gap between virtually everything in the real asset space and the broader markets. Investors have been concerned with what catalysts could unlock that valuation gap. The shifts in the inflationary dynamics we’re experiencing are having more investors say, I really should have some real assets as part of my long-term strategic allocation.