Does inflation protection still have a role in portfolios?
- Despite today’s modest inflation threat, inflation-protected securities can help buffer against tail risk and the normalization of price trends longer term.
- U.S. economic strength will likely keep Fed monetary policy on track for interest rate liftoff this year.
- Adequate savings and realistic investment goals, in addition to inflation-protected securities, can help clients combat the long-term impact of rising prices.
Have you wondered if the current low-inflation environment warrants a change in the way investors plan for potential future inflation? Roger Aliaga-Díaz, senior economist with Vanguard Investment Strategy Group, and Gemma Wright-Casparius, senior portfolio manager for Vanguard Inflation-Protected Securities Fund and Vanguard Short-Term Inflation-Protected Securities ETF (also available as a traditional fund), discussed the question in early March.
What should investors understand about inflation, given the current environment?
Aliaga-Díaz: In the short term, inflation may not be a concern. Right now, there are deflationary pressures globally. That's spilling over into the United States, with oil prices coming down.
But long-term investors are right to remain aware of the tail risk of an inflationary event—that means the remote possibility that something would happen to spark higher inflation.
Let me be clear: We don't think inflation is going to spike. It's more that there's a possibility monetary policies will start working around the globe. The goal of the monetary accommodation occurring globally right now is to try to increase inflation expectations and create some inflation.
Wright-Casparius: Here's the way the bond market as a whole has approached it: We've had this disinflationary trend because of the decline in energy prices and the strength of the U.S. dollar. Inflation expectations are as low as they were in 2012 when the Federal Reserve began its quantitative easing (QE).
Yet now the U.S. economy is growing solidly at 3.0%, not 1.5%. And the Fed is talking about raising short-term interest rates and trying to normalize monetary policy because the economy and fundamentals are sustainable.
The Fed has a window to try to remove the [quantitative easing] accommodation because the rest of the world is becoming accommodative in its monetary policies.
As our economic team notes, the volume of U.S. imports with the rest of the world is a relatively small part of our economy, particularly with Europe, so we shouldn't be seeing that spillover effect.
Yet the market is deeply concerned that, because there's global disinflation and significant risk to global growth, that will be imported into the United States and drag our economy down. That's what the market's priced for. Even though that's not our base case, we still believe it will likely take several years before the economy reaches the Fed's core inflation target of 2% on the core Consumer Price Index (CPI).
Aliaga-Díaz: Yes. Your fixed income allocation, and even your Treasury Inflation-Protected Securities (TIPS) allocation, is pricing in such a low inflation rate, five or even ten years out, that you recognize that at some point those expectations should normalize—not that inflation expectations will get out of control, but they may be higher. As we discuss in more detail in our 2015 economic and investment outlook, our projection of inflation over a ten-year period is between 2% and 3%.
Does it still make sense to have inflation protection? The answer is yes, because there's always the long-term risk of an unexpected event.
Is the market ready for the Fed to start raising interest rates?
Wright-Casparius: While the market doesn't expect deflation, it's saying to the Fed, "We don't think you'll be able to raise interest rates with inflation so low." But the Fed is saying back to the market, "We still think we're going to raise interest rates by mid-2015." Remember, the Fed has been talking about doing this since mid-2012. The Fed hasn't changed its position, so the market could be in for some volatility.
The market is also considering what's weighing on interest rates: How much is geopolitical risk affecting the level of rates? How much is the QE program from the European Central Bank (ECB) likely to depress long-term rates?
Does the market get surprised if the Fed raises rates? I think yes. We almost thought "At least we got that first shock reaction into the market during mid-2013" with what's commonly called the "taper tantrum." Now rates are basically as low, if not lower, than when the Fed did the taper announcement.
Aliaga-Díaz: I think that, more recently, the markets have started to gradually price in a midyear rate-liftoff scenario that's more in line with what Fed communications have been conveying all along, based on the developing strength of the economy.
The Fed isn't likely to remain on hold until inflation reaches 2%. Rather, the Fed needs to account for the lag the impact of its policies will likely have and move ahead of time. The key precondition for moving forward with a 2015 liftoff, though, is that core inflation metrics, such as core PCE (personal consumption expenditures) inflation, are moving in the right direction—that is, upward and toward the 2% inflation objective—while the labor market remains strong.
Wright-Casparius: In some respects, the Fed did such a good job [responding] after the taper tantrum. It basically provided guidance by saying it'd be patient and wait to see a durable expansion. Now we have a durable expansion and it's saying, "We don't have to wait anymore. The U.S. economy is strong enough on its own."
How is global monetary policy influencing the situation?
Wright-Casparius: I think this time you have more foreign money coming into the United States searching for a home, that rates [for long-term bonds] can probably remain relatively low. I think what may change this time are short-term bond rates.
An advantage of the U.S. sovereign debt market is that it's more deep and liquid than other markets globally. If you have to put money to work, this is where you want to put it. Rates in the United States have risen ahead of the first rate hike and are higher relative to other sovereign bonds. Combined with a stronger U.S. dollar, investors have been looking to the United States as a suitable place for investment.
I think so much of that has happened already that it's kind of played out; it's not quite as attractive anymore. But that doesn't mean that, as rates rise periodically in reaction to the Fed raising interest rates, we won't see that next wave of flight to quality from global investors.
The benefit of TIPS is that they prepare you for the unexpected upswing. Anything above 3% in headline inflation is where TIPS really have an opportunity to outperform equities.
Will trends regarding the flight to quality and strengthening U.S. dollar continue?
Aliaga-Díaz: To me, what could put a stop to the flight to quality is if the extraordinary monetary accommodation from both the ECB and Bank of Japan really works. That will mean stabilized conditions overseas, which could potentially put a little bit of a backstop on this one-way flow into the U.S. dollar.
It's very much up in the air at this point if those policies will succeed.
The stronger dollar is a factor that we've taken into consideration in our outlook. Clearly, a stronger dollar generally can hurt the U.S. economy in many ways—not just in making our exports more expensive, but in weakening the earnings of, for example, the large U.S. multinational companies that generate more than 40% of the earnings in the S&P 500.
However, the strong dollar in this case is a result of a stronger U.S. economy when compared with the rest of the world. We saw that in the 1990s as well. Back then, the U.S. dollar surged as the United States went through a period of very high productivity growth and strong employment gains, while Japan, Germany, and many emerging markets were going through a very challenging time. A strong economy with profitable investment opportunities attracts global capital flows and that can create U.S. dollar pressure.
How should investors think about inflation protection?
Aliaga-Díaz: With this deflationary backdrop in mind, does it still make sense to have inflation protection? The answer is yes, because there's always the long-term risk of an unexpected event. But it's probably going to take a long time before higher inflation is a threat.
Investors sometimes face a different kind of inflation than what's reflected in the core CPI. It's always important to keep that in mind. The inflation that the market is pricing in, which is really the inflation based on economic reports, such as CPI, is different from inflation for things such as education or health care. It's not necessarily the same as what you may face as an individual investor.
For example, if you're saving for college, the only inflation you care about is for tuition. In that case, standard inflation-protection instruments may not be enough to cover the much faster inflation rate in college tuition. So ensuring adequate savings and setting realistic investment goals for the portfolio may be more important than betting on a single inflation-protected asset class.
Wright-Casparius: The question I always get from people is, "How come I'm not getting the same rate of inflation as what I see every day [in the news]?"
Aliaga-Díaz: That's because theirs isn't the same "basket" as the one on which the CPI is based.
Wright-Casparius: TIPS are based off the CPI Urban Non-Seasonally Adjusted Index, called the CPI-U NSA. That's very different from what people experience every day [the core CPI]. Subcomponents of the CPI-U NSA include health care, education, auto prices, vacation prices, and airline prices.
The benefit of TIPS is that they prepare you for the unexpected upswing. Anything above 3% in headline inflation—if we got a big, unexpected upside surprise and the economy comes roaring back to life—is where TIPS really have an opportunity to outperform equities.
Even if we expect short-term interest rates to rise because of the Fed's possible actions, investors who don't want the interest rate exposure of a broader active TIPS fund (such as Vanguard Inflation-Protected Securities Fund) can consider a shorter-term TIPS fund (such as Vanguard Short-Term Inflation-Protected Securities ETF). It tends to have a closer correlation to realized CPI inflation.
There will be some interest rate risk if the Fed is pushing up short-term rates. But that volatility in those interest rates should be lower than in our active fund. Investors who are at or near retirement should consider the shorter-term fund.
Aliaga-Díaz: When you build a portfolio, think of inflation risk as one of multiple risks that you're protecting against. In building a portfolio, investors must take into account all types of risk: credit risk, equity risk, interest rate risk, currency risk, and inflation risk, as well as the risk-versus-return trade-off (shortfall risk).
That leads you to think basically about how much inflation protection you want. Just focusing on inflation risk may leave you overexposed to other risks, such as equity-sector risk if you're loading up on inflation-sensitive sectors of the equity market or giving up return if you're overweighting TIPS.
How can a fund manager prepare for what may—or may not be—ahead?
Wright-Casparius: The question is, when the Fed acts and rates are so low, will the financial system be under some stress? I think TIPS will be vulnerable then, as they were during the taper tantrum. When the Fed pushes rates up, TIPS will probably once again lead the sell-off.
In the TIPS fund (Vanguard Inflation-Protected Securities Fund), we obviously have some levers. Our strategy within the fund is a bit different from some of our peers. Given that we didn't anticipate a lot of inflation increase, we bought a fair amount of nominal Treasuries and we moved [a portion of the fund] to cash, which was sufficient to produce some positive returns.
What we can do going forward if inflation disappoints is continue investing in more nominal Treasuries than TIPS, hold more in cash, own different parts of the yield curve and, in terms of maturity, try to sidestep parts of the maturity spectrum that we think will move more quickly than others. Obviously, if inflation resumes its upward trend, the fund's holdings will be largely in TIPS.
How do you approach your own investment portfolio development?
Wright-Casparius: I try to step back and take a very long-term approach. I know the market could go one way one day or month and then the other the next. For my own portfolio, I tend to make contrarian decisions.
Also, I do own inflation-protected securities in my retirement accounts. They've been, over the last 15 years, a great-performing vehicle. And I think that's how you have to approach it—as part of an overall diversified portfolio, and again, it's there for the long haul.
Aliaga-Díaz: All assets have some type of inflation compensation embedded in them on a long-term basis. So I like a balanced approach where I hedge risks—including inflation risk—to a certain degree. But also I'm willing to bear market risks as a source of return.
A market-cap bond portfolio including TIPS would be a reasonable starting point for a balanced risk exposure on the fixed income portion of a portfolio. You don't want to focus only in one risk, such as inflation, since that would lead to an overweight of TIPS, and likely lower long-term returns relative to a broader bond portfolio.
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