One aspect influencing the economy and the markets is the Federal Reserve's stimulative monetary policy via its Quantitative Easing (QE) programs. A concern for market participants is the impact on inflation resulting from the QE programs. Current CPI data shows little inflationary impact; however, is there a point in the future where inflation takes hold? If so, how should investors position their investment portfolios. First though, below are several charts confirming the Fed's influence on some economic/monetary variables.
- Significant growth in the monetary base continues unabated:
- The money supply seems to be "trapped" in banks and is showing up as excess reserves:
- Typically, the excess reserves held by banks would be deployed into the economy by growth in Commercial & Industrial loans. This loan growth has occurred:
- But not at a pace that has increased the velocity of money; hence, this money supply growth has not resulted in inflationary pressure:
Our firm has published a number of posts on inflation and its inpact on investment returns over the years. As long ago as January 2009, we wrote a post, Money Supply Causing Concern With Future Inflation, that looked at the Quantity Theory of Money and velocity's impact on inflation. So inflation was an investor concern in 2009 and has been misplaced, yet this post is going to discuss inflation concerns again in 2013. The point is this slow pace of economic growth, developed economy deleveraging and the high debt to GDP level in many countries may actually be restraining inflation pressures. However, investors should be aware of strategies that can be implemented that might provide a hedge against inflation as it relates to the return generated by one's investment portfolio.
Lazard Asset Management recently published two white papers on asset returns and inflation. A link to both papers is provided at the end of this post. Two important factors are cited that determine the type of investments that do well in various inflationary environments: the rate of GDP growth and the level of inflation.
At the outset of the part 2 paper, Lazard notes, over the "long run" equities are a good hedge against inflation. However, this long run may be thirty years or more and if an investor is older than say 70, the thirty year time period may be irrelevant unfortunately.
So as the above chart shows, equities do provide a good hedge against inflation versus bonds. At high rates of inflation though, real equity returns historically are negative. Lazard notes critical determinants of the best types of investments to hedge inflation are,
"Both the inflation rate and the type of inflation regime are critical to evaluate the degree of inflation protection provided by any asset class. Therefore, it is important to understand the drivers of a given inflationary period. In a regime where inflation is being driven by companies passing on costs to consumers via price increases, alongside a booming economy with strong growth rates, stocks (and also commodities) can offer good inflation protection. This may be explained in part because stocks and commodities both act as real asset investments as they typically benefit from a strong economy and because company profits may rise with inflation as illustrated in Exhibit 2.
Nonetheless, an equity-driven inflation hedge is quite limited if inflation is a result of erroneous monetary policy, commodity shortages, protectionism, extreme volatility in economic data, or inflated wage contracts, alongside a phase of weak growth and deeply embedded structural problems. Stocks tend to generate weak growth under these circumstances, particularly in times of low growth and high inflation."
Finally, the white paper demonstrates that tactically allocating one's investments, even at the equity sector level (and individual stock level) can enhance a portfolio's real return. Exhibt 5 of the Part 2 paper provides industry and style factors investors can consider based on inflation views. Lazard concludes,
"It turns out that portfolios with high inflation betas generally offer better inflation protection compared to portfolios that have been constructed based on the relationship of each stock to a conventional capitalization-weighted index. Not surprisingly, many of the stocks with high inflation betas are concentrated largely in the gold, commodities, raw materials, and technology sectors, but the manufacturers of essential consumer goods, pharmaceutical stocks, and selected industrial stocks also come under consideration for such portfolios... An additional observation regarding inflation betas is that a long-short portfolio (long high inflation beta and short low inflation beta) improves the hedging capability of a portfolio (see Bernard 1982).
...inflation protection is usually only one of several investment goals. It is likely that a focus on inflation protection may introduce opportunity costs or generate additional risks, as it entails heavy concentration in specific sectors or factors and may forgo diversification benefits. Therefore, it is conceivable that in a singular pursuit of inflation protection, an investor may neglect other investment goals, as well as the earnings potential of other stocks, and be subject to valuation implications (stocks that offer inflation protection may become expensive in specific phases when everyone wants to buy inflation protection). In our view, inflation protection is part of a broader goal in a portfolio and, thus, an important task of strategic asset allocation in connection with a comprehensive assessment of investment objectives.
Based on our analysis, a straightforward answer cannot be given for assets that will protect against inflation in every economic environment and in every investment horizon. The recent revival of the inflationary debate has sparked interest in seeking optimal inflation hedges. However, searching for assets that protect against inflation proves to be a complex enterprise, as a myriad of factors affect the inflation-protecting capabilities of financial assets."