Pinning the Tail on InflationPinningtheTailonInflation

The current inflation rate (headline Consumer Price Index) soared to 4.2% percent year-over-year (April 2021), mainly due to base effects, a rebound in energy prices (25.1% YOY) and increase in prices for core commodities (i.e., less food and energy, such as – household furnishings and supplies, and used cars and trucks) (4.4% YOY). The US TIPS implied 5-year breakeven inflation rate also rose sharply to 2.6%, and the 5y5y inflation rate (i.e., average inflation over 5y beginning 5 years forward) rose to 2.3% from 2.0% at the beginning of this year.  Inflation expectations have also been rising in other developed countries.

The Producer Price Index grew at 6.2% YOY (April 2021). Due to pandemic-led supply shortages and changing demand patterns, prices for the industrial commodities less fuels increased by 10.1%. Prices for the transportation and warehousing of goods (for final demand) increased by 7.7%. More broadly, freight rates implied by the Cass Freight Index, which measures overall North American freight shipments and expenditures, jumped 13.7% YOY. This coincides with a shortage in railcars, driving well-publicized port congestion.

The rise in producer prices is pushing through to consumer prices as many consumer staples companies, citing higher commodity prices, have already announced price increases to maintain profit margins. 

As the economy recovers and the US population becomes fully vaccinated, services prices are also expected to increase. Currently, Owners’ Equivalent Rent (i.e., OER, a survey based approach to estimating how much homeowners would charge if they were to rent their houses), with more than a 24% weight in CPI basket, doesn’t yet reflect the rapid rise in housing prices (2.0% vs. 11.9% YOY), but it may yet do so.[i]

Investors concerned about renewed inflation are reminded of the Great Inflation period that began in the late 1960s when demand-led inflation picked up suddenly. With expansionary fiscal policy (Kennedy – Johnson tax cut of 1964, domestic programs for President Johnson’s “Great Society” and defense spending for the Vietnam War) and accommodative monetary policy, by the mid-60s the economy was at full employment with unemployment less than 4%. Producers of goods and services were able to increase prices due to strong aggregate demand.  

Coincidently, the problem of freight car shortage had grown increasingly severe in the 1960s.[ii] Despite opposition from President Johnson, Fed chairman William McChesney Martin Jr. raised the discount rate in 1965 to cool an overheating economy. Like today, monetary policy was not following a clearly defined policy rule but had discretion to adapt to changing circumstances. Yet by the end of the 1960s, inflation exceeded 6%, although it was less than 1.5% just five years earlier. The 1960s ended with a run on gold and a collapse of the London Gold Pool (a group of central banks formed to stabilized gold-dollar parity).

Today, while inflation remains a hotly debated topic, the tail risk of unanchored inflation expectations has clearly increased with unprecedented money supply growth and fiscal stimulus.[iii] Consequently, institutional investors have increasingly inquired about various ways to protect against inflation. 13-F filings show that some institutional investors have recently invested in gold-related assets. However, many real assets besides gold have positive inflation exposures. In addition, these inflation exposures (i.e., betas) differ across real assets (see Figure). Therefore, the selection and allocation to real assets would differ depending on an investor’s specific investment criteria. (Here the betas are estimated at 1y horizon for the period from 1991 – 2020.) 

There are four elements to successful investing in real assets:

1.    Get the sensitivities right: As discussed earlier, sensitivities (i.e., betas) of real assets to macroeconomic (inflation and economic growth) and financial market variables (stocks and bonds) differ substantially.

2.    Know your investment horizon: Relationships of real assets to macroeconomic and market variables vary with the investment horizon. For example, correlation of commodities to inflation varies at a 1m vs. a 3y horizon (0.13 vs. 0.55).[iv]

3.    Incorporate estimation uncertainty: Estimated relationships like correlations and betas themselves vary, and the uncertainty in these estimates generally increases with the horizon. This uncertainty should be accounted for when constructing real assets portfolios.

4.    Reflect your economic environment outlook: Estimated relationships differ across economic environments like stagflation (high inflation, low growth) or overheating (high inflation, high growth). So, a stagflation-focused portfolio may look very different from an overheating-focused portfolio.

RASA (i.e., Real Assets Sensitivity Analysis, a framework developed by PGIM IAS) brings together these four elements for successful investing in real assets. Using RASA, investors can identify those real assets that have high inflation exposure to construct a well-diversified, inflation-hedging portfolio.[v] Also, since real asset funds differ considerably in terms of their inflation exposure, investors can use RASA to identify those funds which are likely to provide strong inflation-protection.[vi] Finally, investors can use RASA to construct bespoke benchmarks designed to provide higher inflation protection than an off-the-shelf benchmark.[vii]