A Case for Inflation Hedge Assets – Part 1

The objective for many portfolios is to minimize downside risk, which leads many advisors to push for more diversification. However, diversification often translates to a greater number of funds instead of a wider distribution of factor exposures. In this post, OFA will discuss one of the most overlooked types of asset: inflation hedge. We will take a look at this asset type, intuitively, from the perspective of business cycle theory. Then, we will discuss the current macroeconomic environment that warrants the inclusion of this asset type.

The Business Cycle

A business cycle is a fluctuation of economic activity. It describes the change of the demand-side of the economy as measured by GDP. Figure 1 shows the business cycle in the United States since 1965 as measured by the output gap. The output gap is defined as the difference between actual GDP and potential GDP. If the output gap yields a positive number, it is an indication that aggregate growth is outpacing aggregate supply; if the output gap is negative, the reverse holds true.

Figure 1: Output Gap (Shaded Area = Recession)

One way to gauge where the economy is in the business cycle is to observe the actions of the central bank, which is the clearest indicator of economic health. Central banks generally tighten monetary policy when inflation is high/rising and productive capacity is running low. Easing will occur when the reverse conditions exist. The business cycle typically occurs in five phases. Figure 2 below summarizes those phases and each of their respective characteristics. Please note that the figure below depicts a general outline of the business cycle.

Figure 2: General Characteristics of a Business Cycle

Inflation Hedge assets will perform well when the expansion phase of the economy is nearing its end. Investors may ask why they should worry about inflation given where we are in the business cycle. We will now discuss why inflation should be a concern in light of the current economic environment.

Current Macroeconomic Environment

The past 25 years have been characterized by declining interest rates and low, stable inflation (2.70% average annual inflation based on CPI and 2.43% average annual inflation based on PCE). This time period is fresh in many advisors’ experience and acts as a “cognitive primer” of their current asset allocation. However, as past performance may not be an indication of future returns, we believe that the current macroeconomic environment is the start of a secular shift, which will be characterized by a sustained, higher level of average annual inflation, and hence, warrants the inclusion of inflation hedge assets. Furthermore, inflation hedge assets help in overall portfolio diversification.

Figure 3: 25 years of Declining Interest Rates and Low, Stable Inflation

One interesting characteristic of the macro environment over the last 4 years is that the Federal Reserve’s balance sheet has continued to expand at a time when the deficit is persistently high and the debt overhang is a major concern. Combined with asset purchases by the Fed for the purposes of suppressing interest rates, the current environment left the government with few choices: increase growth (easier said than done) or increase inflation (easier done than said).

Figure 4: Federal Reserve Balance Sheet (Last 5 Years)

Figure 5: Debt as a % of GDP

How likely are the two scenarios? Real economic growth has been stubbornly low. The latest revised GDP report (Q4) came in below expectations at 0.10%. The headline number was dragged down by big declines in defense spending and inventories. Going forward, government spending will likely remain a drag throughout 2013 as rebalancing to the private sector takes place. The Federal Reserve, in their long term outlook, forecasts nominal GDP growth of 5%. PIMCO breaks the Fed’s GDP forecast down by real growth (approximately 3%) and inflation (2% PCE inflation). The Fed’s forecast can be interpreted as pseudo nominal GDP targeting which implies that, absent real economic growth, the Fed will use inflation to achieve their target nominal growth rate. As such, we believe there is a probability of higher inflation in the future.

Figure 6: Nominal GDP Breakdown

Conclusion

The case for including, or at least considering including, inflation hedge assets in a portfolio based on the above information is as follows:

• Assuming that it is the intention of the Fed to close the output gap outlined in Figure 1, this can only be done by increasing economic production and/or through inflation. As discussed, economic growth remains stubbornly low both in the U.S. and globally. Inflation, on the other hand, is much easier to induce through monetary policy actions.
  
• Based on the Fed’s nominal GDP forecast outlined in Figure 6, inflation is going to play a meaningful part in achieving that target.
  

What is even more interesting to consider, in terms of inflation and GDP, is whether or not the U.S. economy has undergone a structural shift in which 3% real GDP growth per annum is actually achievable.

There are a number of assets that will provide an inflation hedge while also providing different risk/return characteristics. These assets include: inflation linked bonds, commodities, and real estate provide direct inflation hedge protection. Meanwhile, precious metals, currency, and bank loans can also provide some protection.

Source: FactSet, PIMCO, US Department Of Commerce, FRED
Kudos to a friend who refuses to be named for a lively discussion on this topic over gtalk

February 2013 Monthly Market Update

G-20 Summit

Leading into the summit, and based on the sustained and coordinated monetary policy actions of global central banks, the most widely discussed topic of financial market health revolved around currency (de)valuations.

Of particular concern was the aggressive language that Japan’s Prime Minister, Shinzo Abe, used in discussing his intentions of using monetary policy to drive Japan out of their 20 year deflationary economy which, year to date, has seen the Yen depreciate against the USD by 6.7%. More generally, the developed markets have seen their respective currencies weaken against USD while emerging markets have seen their currencies strengthen versus USD. The emerging market economies will be concerned with this currency appreciation as it makes their exports more expensive and exposes them to significant economic risks as soon as the global accommodative monetary policy begins to be unwound.

M&A Activity

In a sign that the U.S. financial markets are beginning to heal, February saw significant activity in the M&A space. The highest profile acquisition / takeover saw Michael Dell and a group of Private Equity investors take Dell, Inc. private via a leveraged buyout. In addition, Warren Buffet made headlines by working with 3G Capital Management to acquire Heinz. There were other sizeable deals that took place in February with the key takeaway being that the cheap debt that has been made available via continued monetary policy initiatives and the cash stockpiles that companies have stashed away on their respective balance sheets is beginning to be put to productive use.

Macro Update

• In Europe, soft economic data reported in February for Q4 2012 brought renewed fears of a global economic recovery taking hold. French, German and Italian economies all contracted in Q4 and signaled the region likely fell deeper into recession at the end of last year. In addition, Italian elections have further added uncertainty to the fiscal austerity measures that region is trying to put in place as Italy’s newly elected Prime Minister, Pier Luigi Bersani, who supports continued “budget rigor” may have to contend with the projected blocking minority that Silvio Berlusconi built in Parliament while losing the election.
  
• As noted above, Japan continues to be front and center as Prime Minister Abe, while toning down his rhetoric on exchange rate targeting, is set to nominate a central bank governor and two deputy governors. As it stands now, Mr. Abe has nominated Haruhiko Kuroda for the BOJ governor position. Mr. Kuroda has been an outspoken critic of the BOJ over the last 10 years and, as such, is expected to use monetary policy (i.e. asset purchases) to stimulate the Japanese economy. Mr. Kuroda’s confirmation is not certain as the Japanese parliament is largely divided outside of Mr. Abe’s ruling Liberal Democratic Party.
  
• In the United States, macro data continues to show improvements in certain segments but is still looking for that “escape velocity” broadly. For January, the housing market continued to show signs of improvement with housing starts coming in at 900K, sales of new homes increasing by 28.9% and inventory of existing homes falling to the lowest level since December 1999. In addition, the ISM Manufacturing Report increased to 53.1 in January from 50.2 in December and consumer confidence surged to 69.6 in February. While initial jobless claims decreased to 344K for the week of February 22, unemployment remained stubbornly high at 7.9% in January and industrial production decreased. GDP for Q4 2012 was revised up to 0.1 from an original print of -0.1.
  

• February saw the release of FOMC meeting minutes suggesting that members have been considering the long term implications of sustained monetary policy intervention and, as such, hinted that open-ended asset purchases may be scaled back/stopped earlier than previously expected. In testimony to Congress, Fed Chairman Bernanke maintained that asset purchases would continue.
  
• Finally, the country awaits the arrival of March 1, as this is the date that mandatory government spending cuts (i.e. sequestration) are set to be implemented. As of this writing, the expectation is that some form of sequestration will occur on March 1 but that the March 27 Congressional meeting to discuss the debt limit will be of more importance to financial markets.
  

We have included select financial market performance for February below.