AUSTIN, Texas, July 23 (Reuters) – Trying to guess financial markets about the inflation outlook is futile. Investors would be better off using market indicators of consumer price expectations and instead focus on how to exceed or hedge against the adverse effects on future spending that such measures imply.
The last three decades have been a period of relatively moderate inflation in the United States with an annual increase in the consumer price index of around 2.3%. Yet even this level of inflation has had the effect of reducing the purchasing power of an uninvested dollar by about half. It is therefore very important that the recent acceleration in the pace of price increases is transient, as predicted by Federal Reserve Chairman Jerome Powell, or more durable.
Brief spurts of high inflation have a much smaller impact on purchasing power than prolonged periods of high inflation. But last year’s Covid-19 shock to the labor market and supply chains means it’s unclear whether the economy is experiencing first or entering a phase of more prolonged price pressures. Market measures of investor inflation expectations point to a moderate recovery in consumer prices in the coming years, but are aligned with Powell’s view that a recent upward spike will be transient. For example, data from the Federal Reserve Bank of St. Louis shows that five-year equilibrium inflation, which reflects inflation expectations over the next five years, is 2.6% per year, close to its 30-year average.
Investors’ collective best estimate, aggregated by market prices, is hard to beat as a guide to what the future may hold. So investors might be better off ignoring the experts and finding a way to outperform or hedge against the inflation already anticipated in market prices.
Over the past three decades, US stocks, non-US developed market stocks, and emerging market stocks have all posted positive real returns. Adjusted for inflation, a dollar invested in the S&P 500 Index in 1991 would have reached over $ 12 by 2021. This represents a 12-fold increase in purchasing power. Likewise, yields on government and global corporate bonds hedged into foreign currencies exceeded US inflation during this period.
True, average real returns on global stocks and bonds were positive, whether inflation was above or below average, with no reliable difference between the performance of each asset class. But just because it was the average result doesn’t mean it was the case every year. Investors who are particularly sensitive to inflation may therefore want to hedge against the erosive impact of rising consumer prices.
One option would be to buy inflation-protected Treasury securities, the returns of which are linked to changes in the consumer price index. If inflation rises more than expected, TIPS owners are compensated by an adjustment for the increase in the CPI. This helps protect investors from erosion of purchasing power.
An alternative is to buy short-dated corporate bonds while using derivatives called inflation swaps to protect against price increases. Such swaps consist in paying a counterparty an amount linked to current inflation expectations in exchange for receiving a sum of money which depends on inflation at a given date. Although this strategy involves more credit risk, it offers higher expected returns than TIPS-only strategies and allows for greater diversification.
Anticipation and hedging against inflation are often important goals for investors. The proportion of assets allocated to each objective can be linked to the investment horizon. For example, a broad allocation to assets that are expected to exceed inflation may be appropriate for investors who plan to save and who do not plan to spend their investment assets for many years to come. Assets that exceed consumer price increases seek to increase the purchasing power of savings, allowing more consumption in the future. On the flip side, investors who are getting closer to the date when they will stop saving and start spending their savings may want to have more certainty about the value of their wealth after adjusting for increases in income. price. In this case, a greater allocation to inflation-hedging assets can help provide greater certainty.
Investors don’t need to get ahead of the markets or undermine their portfolio goals to get ahead or hedge against inflation. However, they must avoid overreacting to short-term fluctuations in consumer prices.
– Gerard O’Reilly is Co-Managing Director and Chief Investment Officer at Dimensional Fund Advisors, an asset manager that managed $ 660 billion as of June 30.
Editing by Swaha Pattanaik and Amanda Gomez
Reuters Breakingviews is the world’s leading source for agenda-setting financial information. As the Reuters brand for financial commentary, we dissect big business and economic stories from around the world every day. A global team of around 30 correspondents in New York, London, Hong Kong and other major cities provide real-time expert analysis.
Sign up for a free trial of our full service at https://www.breakingviews.com/trial and follow us on Twitter @Breakingviews and at www.breakingviews.com. All opinions expressed are those of the authors.