Inflation hedging: Being unplugged from the Matrix?

Add to this the lag effect of board cycles and decisions can become quickly time sensitive. When it comes to inflation, specifically, committees are being presented with two realities.

One is of reversion to moderate, range-bound inflation underpinned by peaceful globalisation, one which is predictable typifying monetary eased markets since the Global Financial Crisis.

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Cyclical reversion to mean offers committees a sense of equilibrium across asset classes that allows relied-upon long-term models to work.

The other reality is one of volatile inflation; unpredictable, sporadic and difficult to control, a return to boom-bust markets of the 1970s and 1980s.

A symptom of supply shocks, geopolitics and some say a decade of extravagant money printing by central banks. Here long only models can quickly decay and hedging becomes ever more important.

Committees have a choice: take the blue pill, the story ends, we wake up tomorrow and believe whatever we want to believe, and hope then that inflation comes under the control of central banks in 2023; or take the red pill, stay in wonderland, and see just how deep this inflationary rabbit hole goes.

When it comes to inflation, over the summer, we were already seeing markets respond to inflation risk, and asset volatility was on the rise.

The nascent question before us then was this; does inflation revert sooner, what if it does not and how is it translating into volatility and the value of our client portfolios? We have already seen come evidence of the ‘what next’.

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On one hand we have been hearing that higher inflation is ‘transitory’, for over two years now. Indeed inflation is transitory but anything but temporary.

How long might the current cycle last? Forecasts range widely from months to years, for Q4 2022 they look to be around 11% CPI peak, falling to around 5% in 2023. However there were outliers such as Goldman Sachs’ August forecast of 22%!

Additionally, in its June paper Inflation: a look under the hood the Bank of International Settlements wrote: “Transitions from low-to-high-inflation regimes tend to be self-reinforcing.”

They noted: “As inflation rises, it naturally becomes more of a focal point for agents and induces behavioural changes that tend to entrench it, notably by influencing wage and price dynamics.”

In this regard, optimisation is not resilience. You cannot model for higher inflation reliant on yesterday’s low inflation prices.

The LDI, repo and gilt market turmoil in September was a good example that complexity does not equate resilience. Correlation then is not always causation, probabilities are problematic and forecasts are forever fragile.

How then do we build resilience? Firstly recognise that higher inflation is a source of rising portfolio volatility. Secondly, building resilience is categorically not about complexity or chasing outperformance. Something management can get plugged into, owing to the commercial and competitive pressures of our industry.

We also know that in accumulation our clients are net buyers of volatility, they actively buy risk to grow their portfolios over time. Sometimes not buying enough risk diversifies away an opportunity cost.

However in drawdown clients become net sellers of volatility, what many call sequencing risk and has a very erosive effect. Here risk overtakes opportunity cost. On the projections I am seeing a sustainable level of real income for 25 years is only 3.5% and it is falling rapidly.

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It is no surprise that the cost of living is dominating the news and our client conversations.

We know that inflation is occurring broadly and deeply, with many factors conflating together, and the result is complex both inside and outside of the household. Resilience then is managing that volatility within your client portfolios, as assets reprice inflation today and into the future.

To do this committees need to better appreciate that a feature of inflation is that it experiences different ‘regimes’ and that asset classes behave differently in those regimes.

Research supports that inflation-hedging assets can underperform in deflationary and high inflation periods, that they do well and outperform broader equity and bond Beta when markets experience moderate inflation.

Whereas in low inflation periods, equity and bond Beta offer higher real returns than all inflation-hedging assets. By comparison in higher inflation periods; commodities and bonds typically suffer, equities do better, REITs outperform but Gold specifically soars.

To conclude that there is indeed some value for money from inflation hedging, but also an opportunity cost, and a timing and selection risk to not diversifying those hedges versus Beta.

Yet it has been a stark reminder that equities too are a geared instrument of bonds and that gearing reflects back into equity price volatility when inflation raises fears of interest rate risk. Debt to equity ratios in your allocations thus matter, providing some indication of a portfolio’s sensitivity to both inflation and rising rates.

It is one reason why the 60/40 balanced portfolio typically works best long-term when there was some cyclical equilibrium between equities and bonds.

But since the GFC that equilibrium has been broken. It is why most balanced models were left holding more nominal risk in equities and high yield bonds than a decade previous.

Going into 2022 our balanced risk models were also  left proportionately exposed to more risk on a real-adjusted basis than for a similar portfolio in a lower inflation period.

Going into 2022 we now know there was a systematic under allocation to inflation hedged assets, that the market, ‘BETA’, was mis-positioned for inflation risk. When it comes to inflation then we are being presented with two realities.

Choosing either is critical because inflation erodes the purchasing power of any portfolio. To risk underweighting our inflation hedges or risk paying too much for them? When it comes to inflation it feels as if committees need to be unplugged to truly see that choice.

Jon Beckett is a non-executive director and author of New Fund Order 

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