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Are You Prepared for Unexpected Inflation?

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Greg Liebl, CFA

Director, Investment Strategy

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Could unexpected inflation harm your portfolio?

As the Department of Labor announced July 12, the current US inflation rate is 2.9%. It’s a number that’s been creeping steadily upward. In fact, it’s the highest it’s been since 2012. (And as you may recall, as recently as April 2015 it was as low as -0.2%.) That said, inflation remains close to the Federal Reserve’s target rate of 2%—meeting the Fed’s mandate to balance price stability with maximum employment—and according to his recent announcements, Fed chairman Jerome Powell doesn’t seem to expect inflation to jump anytime soon.

The key word here is expect. And we say that not necessarily because we disagree with Chairman Powell’s outlook. Rather, what we mean is that it’s not expected  inflation most investors have to worry about. It’s unexpected  inflation.

Why does unexpected inflation matter?

For most investors, maintaining the purchasing power of their assets over the long run is a primary concern, especially when future liabilities or spending needs aren’t fixed in today’s dollars. This means their portfolio’s nominal return must outpace inflation so that their real return—the return after adjusting for the impact of inflation—is positive. For most risky assets, this isn’t a problem because part of their expected return is directly tied to being compensated for expected inflation. And when inflation expectations become reality, most investors do pretty well given their exposure to traditional assets, such as stocks and bonds.

But what happens when the inflation that materializes is different, or drastically different, from what was priced in or expected? The result can have a profound effect on returns because asset prices have historically been much more sensitive to inflation surprises than inflation itself.

Most portfolios already carry allocations to more traditional assets, such as stocks, bonds, and cash, but may lack exposure to assets that do well during periods of unexpectedly high inflation. It’s in this environment, however, that an investor’s portfolio may be most vulnerable. Not only can its purchasing power be eroded by higher-than-expected inflation, but its market value may also be diminished by falling stock and bond prices. Investors looking to hedge this risk might want to think about increasing their exposure to asset classes that have a positive expected return when unexpectedly high inflation hits.

Which asset class performs best during unexpected inflation?

Hint: You may be eating it. Or wearing it. Yes, it’s commodities—corn, cotton, gold, and the like—which tend to reprice to the benefit of the investor as recast inflation expectations are reflected in higher forward prices. As you can see below, the historical numbers bear this out.

Potential Parametric solution

Commodity-sector performance in periods of high inflation
Commodity-sector performance in periods of high inflation graph

Source: Parametric and Bloomberg as of 12/31/2017
Disclosure: US equities represented by MSCI USA Gross Total Return USD Index, international equities represented by MSCI EAFE Net Total Return USD Index, US corporate bonds represented by Bloomberg Barclays US Corporates Total Return Index, REITs represented by FTSE NAREIT All Equity REITs Total Return Index, diversified commodity represented by Diversified Commodity Basket model. For Informational purposes only. Past performance is not indicative of future results. It is not possible to invest directly in an index.

But as you can also see, the performance of any given commodity can vary widely during periods of high inflation, and, as a result, which individual commodity or sector will outperform is impossible to say in advance. Technological innovation, weather patterns, labor strife, broader economic patterns, and even the political climate all affect inflation sensitivity. And any one of these could cause inflation to turn up in rising energy prices, higher food costs, or greater input prices for manufacturers. To us, this debunks the commonly held belief that one commodity, or commodity sector, provides “better” inflation protection than another.

The bottom line

Inflation may continue to be held in check for several years to come. Or something unexpected may happen, in which case it’s important to remember that very few assets perform well during periods when inflation exceeds expectations. It’s in these environments in which commodities, relative to either stocks or bonds, have historically offered the greatest opportunity for positive performance.

But it’s also important to remember that, as we’ve shown, individual commodity or sector performance during periods of unexpectedly high inflation is at best a guess. That’s why we advise that including a broadly diversified set of commodities in a portfolio can help protect investors from the worst inflationary storms.

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The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss. Prospective investors should consult with a tax or legal advisor before making any investment decision. Please refer to the Disclosure page on our website for important information about investments and risks.