Over the past three years, inflation expectations have come full circle, falling significantly in mid-2014, rebounding from a low in February 2016, and stabilizing in 2017. Contrary to some market commentary, we believe that the US economy has reached the point where the risk for inflation is substantially tilted to the upside.
This shift to an environment in which inflation may return to more normal levels has important implications for investors. An allocation to real assets can protect against inflation and diversify a portfolio while generating current income and offering capital appreciation.
Emerging inflationary pressures
Measures of core inflation (which excludes volatile energy and food prices so more accurately reflects underlying inflation) gradually began to rise in the second half of 2015, as the US economy continued its long recovery from the GFC. The year-on-year change in the core Personal Consumption Expenditures (PCE) price index (the preferred measure of the Federal Reserve) rebounded from a near-term low of 1.3% in July 2015 to 1.8% in February 2017. The year-on-year change in the core Consumer Price Index (CPI) rose as well, from 1.6% in December 2014 to a range of 2.0%–2.3% over the past year.
This acceleration in inflation has been slow in part due to the plunge in oil prices and the rapid strengthening of the US dollar, but the recent rise in core inflation roughly coincided with the fading base effects of low oil prices and rising import prices.
The acceleration in US wage growth is evidence that cyclical pressure is building, as labour markets tighten and the economy nears potential. The year-on-year change in average hourly earnings bottomed at 1.5% in October 2012 and has since risen to 2.7%. Rising wages also broadened in the last two years. Unlike in the early 2000s, when workers at the top end of the wage scale experienced the strongest gains while workers with lower income experienced none, recent data shows a meaningful increase for nearly all income levels.
A strengthened global economy also is providing support, as highlighted by the International Monetary Fund, which recently reaffirmed its view that the global economy will grow more rapidly and more broadly across developed and emerging economies in 2017.
We believe we have reached an inflection point for inflation. Deflation risks have been replaced by rising inflation expectations and, based on cyclical factors alone, we believe inflation of 2.0%–2.5% is likely. Furthermore, there is structural risk from a possible backlash against globalisation, which could lead to protectionism and higher prices. In this scenario, inflation could exceed 3.0%.
Hedging against inflation
Given this risk, investors should revisit their portfolios to ensure they have assets that can protect against inflation. Inflation can corrode purchasing power even at moderate rates. A 0.25% month-on-month increase in the CPI, or about 3% annualised, compounds to around 15% loss in purchasing power over five years.
Thirty years ago, investment options were limited, mainly to gold and large cap equities, but today’s investors can hedge against inflation while also maintaining their investment plans. Because inflationary pressures are likely to be relatively moderate, investors should consider assets that also offer capital appreciation or income. Thus, investors can be ‘paid to wait’ if inflation is dormant. These include real assets – real estate, commodities and infrastructure – as well as inflation-linked bonds and equities with ‘pricing power’. Key features of these inflation-hedging assets include:
- Real estate, which includes rental apartments, businesses, and office complexes, can offer stable cash flows because many have lease structures in place.
- Commodities contribute to headline inflation, and have historically outperformed equities and bonds when inflation rises.
- Infrastructure assets are positively correlated with inflation because they tend to consist of monopolies (e.g., bridges, toll roads, airports) with few alternatives for consumers, giving the ability to maintain margins by passing on price increases.
- Inflation-linked bonds provide a real yield for investors by contractually linking inflation to principal and interest payments. When issued by government entities, they are usually seen as low-risk diversifiers.
- Companies with pricing power enjoy sustained demand for their product or service, passing on price increases to customers without losing market share. Equities also offer exposure to growth, and may provide returns even if inflation is dormant.
Liquid versions of these assets offer the added benefit of flexibility, allowing for allocation changes in response to different manifestations of inflation. For example, real estate would benefit from rapidly rising property prices and rents. Commodities would benefit if the US dollar weakened. Infrastructure would benefit from fiscal stimulus targeting increased infrastructure spending.
Ron Temple is Managing Director and Portfolio Manager/Analyst at Lazard Asset Management. This document is for informational purposes only and does not constitute an investment agreement or investment advice. All opinions expressed herein are as of the date of this article and are subject to change.