Preparing for higher inflation and interest rates
After so many years of extreme monetary policy, of public and private deleveraging, of very low (to negative) interest rates and yields, and of slow economic growth and subdued inflation, the world is changing at the hand of Donald Trump. Investors are already preparing for different times, by selling bonds, buying cyclicals and financials, and in particular, trying to protect their portfolios against rising inflation.
Traditionally, real estate and inflation-linked bonds have been good hedges against inflation, but depending on the exact path taken by macro developments, this is not true at all times. Investors look for real estate and inflation-protected bonds not only as hedges against inflation, but as a way of achieving higher diversification.
The traditional view on portfolio composition that splits funds across asset classes is somewhat obsolete because such asset classes are usually highly correlated, which means that whenever there is a crash in the broader market, investors end up completely unprotected.
Today’s more sophisticated investors look for a risk-based allocation that instead allocates funds across factors or groups of assets by risk-type. One of those factors or specific categories that has been growing fast in terms of investor interest is real assets, which offers great diversification to a traditional equity-bond portfolio while protecting for rising inflation.
One of the greatest challenges for investors to deal with in 2017, is to live without the FED. The extended rise in the equities market has been largely driven by unconventional policy measures that kept interest rates artificially low for a prolonged period of time while creating cash piles that were funnelled into financial assets to bid their price higher.
But with the U.S. economy now nearing full employment, and thus creating some wage and price pressures while Trump is expected to loosen fiscal policy, an acceleration in inflation and a faster interest rate hike is a scenario that can’t be ignored by investors. It is time to look for assets that can deliver returns in excess of inflation and asses that can survive a scenario of rising rates.
Regarding interest rates, we can’t say outright that if they rise, the equity market will crash. Bonds are deemed to underperform because of the inverse relationship between bond prices and yields. But equities are impacted by two opposing effects.
It is time to look for assets that can deliver returns in excess of inflation and asses that can survive a scenario of rising rates.
First of all, higher rates reduce the discounted value of future cash flows and should shrink equity valuations. But rising rates are often associated with improving economic conditions, which should be positive for equities. These two opposing effects combine in a complex relationship that makes it difficult to disentangle the final effect on equity prices.
In general, the negative effect generated by a slow rise in interest rates is outpaced by the positive effect of the associated economic growth and should be positive for equities.
But when interest rates rise faster, the odds of a recession occurring increase and then equities tend to underperform. That may happen if inflation rises faster than anticipated. In a similar fashion, when interest rates decrease slowly, its positive effect is outpaced by the sluggish economic performance often associated with such a scenario. Equities tend to do badly. But when interest rates decline fast, equities do much better.
Summing it all up, equities do better when interest rates rise slowly and when interest rates are cut more aggressively. We are currently at the juncture where equities have already risen over many years, which means the risks of a faster tightening are higher and thus require investors to take a more precautionary approach.
The power of real assets
In a scenario where bonds are expected to underperform and equities become riskier, a good way of improving the expected performance of a portfolio is to invest in real assets. These assets may do very well under a scenario of rising interest rates and rising inflation, providing diversification and income.
Until recently, investors looking to protect against such a scenario concentrated on investments in real estate (through REITs and direct property ownership) and (eventually) inflation-linked bonds. Very few consider the commodities complex and infrastructure. And even fewer look at timber and farmland, even though these assets offer the power of low correlation with the rest of the group.
…equities do better when interest rates rise slowly and when interest rates are cut more aggressively.
There is no agreement on what constitutes a real asset. Many simplify the definition by saying it is a tangible, hard asset. Others like to extend the definition to consider it as a good that is independent from variations in the value of money, that is, which protects against inflation, keeping the purchasing power of the owner across time. Such a definition would extend the range of assets to equities, fixed income, and futures, including not only physical property, infrastructure, and natural resources but also inflation-protected bonds.
For the intent of diversification and inflation protection, I believe the broader definition to be the best, under which a real asset is some form of ownership, being it in the form of a tangible asset or a claim on any tangible asset, which offers protection against inflation. Viewed in such a way, there’s no reason for investors to invest solely in REITs, because there are other ways of building a portfolio to protect against inflation in a much more diversified way.
Building your own inflation-protected portfolio
Investors can always pick up property, infrastructure, commodities and other inflation hedges individually. But, as it is difficult to keep a properly diversified portfolio when dealing with smaller sums, it is sometimes better to use the power of index investing.
In the same way that it is possible to invest in S&P 500 Value or S&P 500 Growth, there is also an option for real assets. Some examples include the Flexshares Real Assets (NASDAQ:ASET), provided by Northern Trust, and SPDR SSGA Multi-Asset Real Return ETF (NYSEARCA:RLY). Both offer exposure to a range of real assets aimed at protecting against inflation.
At the end of last year, S&P created a new index to benchmark real assets – the S&P Real Assets index. Unlike other real assets indexes, this one offers a broader range of exposure because it considers not only real estate, infrastructure, commodities, natural resources, and inflation-protected bonds, but also equity, fixed income and futures exposure. Additionally, the fund also considers an investment in timber and forestry, which has been largely ignored by investors and ETFs, but which is one of the few sectors that is largely uncorrelated with the broader market.
According to S&P, the new index offers a correlation with inflation of 0.43 and an inflation beta of 4.2, which means that the fund rises 4.2% on average for each rise of 1% in inflation. If investing solely in property, an investor would get a correlation with inflation of just 0.20 and an inflation beta of 3.0. If investing only in inflation-linked securities, the respective figures would be 0.65 and 3.2, S&P claims. S&P Real Assets offers a hedge against inflation and a great deal of diversification.
Unfortunately, there is no easy way of investing in the S&P Real Assets index because there is no ETF mirroring its performance as of yet. It is particularly difficult to get exposure to fixed income just related to infrastructure, property, natural resources and commodities. Eventually, in a few years (or even less) some ETF will become available on this index, but for now investors need to stick with the Flexshares or Northern Trust offers pointed out above, or maybe just build a portfolio themselves.
In an attempt to get a degree of diversification closer to that offered by the S&P Real Assets index while still keeping things (relatively) simple, I selected a possible portfolio alternative configuration, as presented below, which investors may keep track of.
The above selection includes the same sectors as the S&P Real Assets index but it is a little tilted towards equities in terms of asset classes. The reason for this is related to the difficulty in finding fixed income specifically related to the sectors we’re looking for. At the same time, it shows an increased exposure to Timber & Forestry, which is underrepresented in S&P’s portfolio. This sector offers more diversification power than many believe and may offer some great advantages to the final portfolio.
Looking back at YTD performance, our new real assets portfolio is up 6.98% with standard deviation of just 0.52%, which compares with 10.82% and 0.82% for the S&P 500 respectively.
The aim is not to outperform the S&P 500 in terms of returns (because the risk involved in the real assets portfolio is much lower), but rather to explore the power of diversification and inflation-protection. Nevertheless, on a risk-adjusted basis, this portfolio shows a better Sharpe ratio than the S&P 500.