Chief Investment Strategist
While we do not see inflation as a near-term threat, longer-term risks may be building. Slowing global growth and post-financial crisis deleveraging have led to disinflationary trends in developed economies, as demonstrated by current U.S. consumer price inflation of just 1.3%. But the ultra-easy monetary policy unleashed in reaction to this slow-growth environment does raise the risk of a monetary-led increase in inflation over the next five years. With most investors focused on increasing the real purchasing power of their portfolios over time, we believe this increases the importance of real assets (those assets positively correlated with inflation) in portfolio construction. Our research confirms the strong positive correlation of commodities with inflation, but with a couple of twists. First, while the widespread use of futures-based strategies still makes sense as it provides the highest inflation correlation and the strongest diversification, we believe buying the equities of natural resources producers provides better long-term return potential. Second, we believe investors looking to inflation-protected securities (such as Treasury Inflation Protected Securities, or TIPs) should focus on the shorter-maturity issues. Our research indicates these shorter maturity securities have the highest correlation with inflation, while the longer maturity securities are much more affected by changes in interest rates. We think these research insights into real assets will lead to superior portfolio construction when contemplating the impacts of inflation.
EXHIBIT 1: THE GREAT MODERATION
Source: Robert Shiller Database, Northern Trust. Inflation is represented by the Consumer Price Index (CPI) from 1913 through August 2012; prior to 1913, inflation is represented by the Robert Shiller Database.
Exhibit 1 highlights the substantial volatility in consumer price inflation witnessed up until the early 1950s. During that time, both inflation and deflation posed a considerable risk; as an example, in 1920 a 23% increase in prices was immediately followed by a 16% drop. Fortunately, these types of price swings have moderated greatly over the last several decades. After inflation nearly hit 15% in March 1980, Federal Reserve Chairman Paul Volcker hiked the Fed Funds rate to 20% to combat inflation. This led to the onset of a sustained period of moderate inflation with the Consumer Price Index (CPI) averaging just below 3% since 1982.
Despite current inflation levels hovering under 2%, many investors are concerned that inflation will once again emerge as a threat to the economy given the massive expansion in the balance sheets of global central banks. In our recent Five-Year Outlook (July 12, 2012) we raised our global inflation outlook from 3.0% to 3.3%, as we believe policy makers are increasingly viewing inflation as one of the tools to reduce sovereign debt loads. Given this outlook, we think any serious portfolio construction effort needs to incorporate asset classes that provide sensitivity to rising prices. Over the history of our data, which dates back to 1970, the asset class that is most responsive to inflation has been commodities.
EXHIBIT 2: COMMODITIES: THE SWING ASSET CLASS
Source: Bloomberg, Ibbotson, Northern Trust; monthly data, 12/31/1970 through 12/31/2011.
Exhibit 2 contains the median annual total return of the MSCI U.S. Equity Index, the U.S. Intermediate Government Bond Index and the Goldman Sachs Commodity Total Return Index (GSCI) during various inflationary environments between 1970 and 2011. Although the Dow Jones-UBS Commodity Total Return Index (DJ-UBS) is a more diversified futures-based index, we used the GSCI in this analysis as the two indices are highly correlated and the GSCI has a longer performance record.
Commodities have performed best during periods of high inflation, significantly outperforming both equities and fixed income when inflation was above 4%. This relationship with traditional asset classes reverses when inflation falls below 4%. In fact, when inflation is below 2% the median GSCI return is -14.1%; nearly 30% and 23% less than equities and fixed income respectively (consider it the price of inflation insurance). Along with the absolute level of inflation, the direction of inflation appears to also have a relationship with asset class returns. Commodities tend to perform best in periods of rising inflation while equities have the best returns during periods of falling inflation.
Worth noting is the outperformance of fixed income over equities in the 4% to 8% partition not something you might expect. However, digging deeper we find that a large number of those observations were during the 1980s when bonds were priced for ongoing high inflation (such as experienced in the 1970s), and investors were pleasantly surprised with inflation of only 4% to 8%. Unfortunately the current 10-year U.S. Treasury (UST) yield of 1.6% provides no such cushion for a positive inflation surprise short of a fall into deflation.
While commodities have shown a strong sensitivity to inflation, a further analysis of futures-based commodity indices (such as the GSCI and DJ-UBS indices) is warranted.
EXHIBIT 3: DISSECTING FUTURES-BASED COMMODITY RETURNS
Source: Bloomberg, Northern Trust.
Futures-based commodity index returns are composed of three primary parts the spot price return, the roll yield and the collateral yield (a less quantifiable diversification return is also present, but not the focus of our analysis). These three items are defined in more detail below:
- Spot price return:A simple measure of how much a commoditys spot (contract closest to maturity) price has appreciated or depreciated over a given period.
- Roll yield: To avoid having to take physical delivery of maturing futures contracts, investors sell the contract about to expire and buy a new contract with longer shelf life. The gains or losses associated with this event depend on the amount of backwardation (longer-dated future contract priced lower than expiring contract) or contango (longer-dated future contract priced higher than expiring contract), respectively.
- Collateral yield: Investing in commodities futures only requires a percentage of the cost to be presented at time of purchase. To prevent holding a leveraged position, the amount of money not required for the down payment is invested in safe assets (usually 30-day Treasury bills), which earn interest.
In simple terms, spot price return and roll yield can be combined into one line item of gains or losses the investor receives for price action that exceeds or falls short of what is already priced into the futures curve, while the collateral yield is what the investor earns on the money not required to be posted.
As Exhibit 3 shows, the composition of these three sources of returns has changed over time. In the 1970s, there was a fairly even contribution, leading to robust annual returns. In the 1980s, commodity prices actually fell but less than what was priced into the futures curve and collateral yield also provided additional returns, while the 1990s witnessed returns only through collateral yield. Finally, in the 2000s and the current decade there has been a trend of falling collateral yields (now close to zero) and offsetting spot price returns and roll yields (implying a state of contango in the futures curves). While Exhibit 3 shows the GSCI, a similar pattern has developed in the DJ-UBS index as well.
In response to the roll yield issue highlighted above, alternative futures-based indices have been developed that invest in futures contracts further out the futures curve where less liquidity is offset by more favorable contango/backwardation relationships. Other indices, such as the Alternative Benchmark Commodity index, seek to provide additional returns through exploiting risk-factors that have shown historical efficacy (such as momentum).
EXHIBIT 4: INFLATION PROTECTION WHEN YOU NEED IT MOST
Source: Kenneth R. French Data Library, Northern Trust.
To assess the effectiveness of the strategy we compared the performance and sensitivity to inflation of natural resource stocks (proxied by the Agriculture, Mining and Oil sectors) against broad-based equities and the GSCI index over different inflation regimes. During periods of high inflation (as seen on the left panel of Exhibit 4), correlation of natural resource equities ranged from 0.30 to 0.42, comparable to 0.40 for the GSCI index, while broad-based equities exhibited a negative correlation. Although natural resource equities underperformed the GSCI, they still provided investors with a positive real return during a period of significant inflation. Over the longer-term, the equity premium becomes apparent, as natural resource stocks outperformed the GSCI noticeably, while still reflecting a positive sensitivity to inflation. Our conclusion is that while inflation protection can be suitably achieved through exposure to commodity indices, longer-term exposure through natural resource equities may provide investors with a higher total return.
Complementing commodities in a real asset portfolio is the use of inflation-linked fixed income, known in the United States, as Treasury Inflation Protected Securities (TIPS). This asset class is explicitly linked to the inflationary environment through the inflation-derived adjustment made to the principal of the debt issuance. However, as the duration of the underlying debt securities are increased, the exposure to inflation becomes muted and turns into a mix of inflation and duration exposure. This can be seen in Exhibit 5 below.
EXHIBIT 5: ALL TIPS ARE NOT CREATED EQUALLY
Source: Barclays Capital, Northern Trust. Correlations use data from 8/29/2003 through 6/30/2012.
The overall TIPS index, which has an average duration of 6.5 years, shows a fairly equal correlation to both inflation and duration (with both factors having a statistically significant influence on return variability). However, once you segment by maturity buckets, you get some interesting results. In the 0- to 5-year bucket, inflation-protected securities are very sensitive to inflation while actually showing a negative (though not statistically significant) correlation to duration. As the maturity buckets increase in years, duration becomes a much bigger driver. We think this data clearly supports focusing the use of TIPs on the shorter maturities to maximize the inflation sensitivity while minimizing interest rate risk.
In all of these studies, it is worth noting that getting accurate measures of sensitivity to inflation is difficult because the market anticipates various inflation expectations. We attempt to adjust for this by looking at lagging inflation data. For example, a three month lag of inflation would mean we are comparing the year-over-year asset class returns through June 2012 to the year-over-year inflation experience through September 2012. When we do this we see a general increase in correlations across asset classes, implying some anticipation is taking place. Exhibit 6 shows these correlations with no lag and a 3-month lag, going back 10 years. Here, it must be noted that the 10-year window used in the analysis is sub-optimal; but it does represent the oldest-available pure monthly historical data for all asset classes represented in the real assets category. Ideally, we would like to go back further in time to see how these asset classes hold up in true inflationary periods (such as the 1970s) but, in our series, year-over-year inflation only gets as high as 5.6%. Despite this short-coming, we still believe there is sufficient variability (including deflation of 2.1% at one point) to gain some insights into inflation sensitivity.
As noted previously, the various commodity indices both futures-based and equity-based show high levels of correlation and this generally improves when accounting for some anticipation in the markets. TIPS show lower levels of correlation, but this is influenced by the inefficiency of the official TIPS index (Barclays TIPS Index); using a lower duration TIPS index would provide higher correlations (as shown in Exhibit 5).
EXHIBIT 6: NATURAL RESOURCES DOMINATE INFLATION
Source: Bloomberg, Barclays Capital, Northern Trust. Correlations use 10 year data history.
Global Real Estate is an asset class, which we group into real assets, that does not have the same level of empirical support as the others; correlations are at about the same level found in broader equities. However, our decision to group Global Real Estate into real assets is based off a fundamental view that rental income is levered to inflation. Rents can be raised as general prices rise, while the high fixed costs of real estate provide operating leverage. Essentially, this provides a variable-rate fixed-income contract but with an equity risk premium attached to the principal. In the current low-rate environment, the current dividend yield of 3.8% provides some protection against capital depreciation while the positive correlation to inflation makes Global Real Estate an attractive provider of income in an inflationary environment.
Complementing the use of Global Real Estate is Global Infrastructure, which has recently been more highly correlated to inflation and sports a current dividend yield of 4.9%. Global Infrastructure companies range from airports and toll ways in the most direct way, to broad-based plays like timber and shipping. The most attractive infrastructure companies are those that have the pricing power to provide steady inflation adjusted cash flows (i.e. highly regulated utility companies are less appealing from an inflation perspective). We see Global Infrastructure continuing to expand over the next decade as government and global bank deleveraging makes project financing more difficult and feel this asset class fills the void between Natural Resources and Global Real Estate in a well-diversified real asset portfolio.
One asset class whose correlation to inflation has been less clear of late has been Gold. Exhibit 7 shows what appears to be a departure from the old relationship Gold had with commodities, beginning with the financial crisis of 2008. Part of this is due to the collateral and roll yield issues highlighted earlier in this report. However, we feel a major reason for this departure is that Gold is now acting more like an alternative currency than a real asset a reclassification we formalized in our 2012 Five-Year Outlook. As major central banks across the world more than doubled their balance sheets in the last three years, the prospect of currency depreciation is on investors minds.
EXHIBIT 7: A NEW TYPE OF GOLD
Source: Bloomberg, Barclays Capital, Northern Trust.
Additionally, we are facing the prospect of additional money printing in the coming months as we await the prospects of a third round of quantitative easing from the U.S. Federal Reserve and a bond buying program from the European Central Bank. Movements in the price of gold over the last four years have been primarily driven by prospects of monetary expansion, and it is through this lens that we will judge its future prospects.
With the near-term outlook for inflation muted, the cost of inflation insurance is not very high. The DJ-UBS index has risen less than 4% this year, as Chinese growth concerns have tamped demand and investor sentiment. While we arent yet calling for reacceleration in Chinese growth and a resulting jump in commodity demand worldwide, we would still encourage strategic allocation to real assets to help protect long-term purchasing power. While the traditional approaches to real assets still hold merit, we believe investors will benefit from our work on the best approaches to commodities and inflation-protected securities. For those investors with a long-term approach and an ability to tolerate higher volatility, we think an equity based approach to commodities exposure makes sense. This provides reasonable inflation-sensitivity while potentially generating a higher total return. With inflation-protected securities, we would go against the instincts of many investors (who might view longer maturities as providing more inflation protection) and focus on shorter maturities where you maximize inflation sensitivity and minimize interest rate risk. With these improvements, we think investors can improve the real asset portion of their portfolios.
Special thanks go to Peter Mladina and Jordan Dekhayser for research insights, and to Ben Goetsch for data research.
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Northern Trust and its affiliates may have positions in, and may effect transactions in, the markets, contracts and related investments described herein, which positions and transactions may be in addition to, or different from, those taken in connection with the investments described herein. Securities mentioned are for illustrative purposes only and are neither a recommendation nor an endorsement.