MARKET expectations are shifting to focus on when, not if, inflation pressures will re-emerge and volatility will revert to more normal levels. How should investors respond?
There are multiple sources of volatility that can affect asset prices and investor portfolios, but there are two significant ones for financial markets. Since volatility has been extraordinarily low for an unusually extended period and, until recently, was coming down, the return of volatility might just be a function of reverting to the mean as monetary stimulus is tapered in the US, the UK and Europe.
If, as expected, monetary stimulus has been effective and growth has improved, then a reversion in volatility to more normal levels is likely to be benign and conducive to the compression of premia in risk markets.
However, if renewed volatility is the result of a spike in inflation risk, the consequences could be more severe. Prices in asset markets are driven by both realized inflation and anticipated inflation, which can be triggered by shocks in consumer prices, producer prices or employment costs.
If volatility is driven by sharp rises in inflation or inflation expectations, equity and bond valuations will have to adjust quickly, which can be bumpy. Often central banks respond to a rise in inflation or inflation expectations by tightening policy or talking about higher rates, prompting further volatility. So far, that has yet to happen.
How investors might respond
The appropriate response to higher volatility also depends on the reasons for the increase. If volatility rises on inflation concerns and growth prospects remain uncertain, then over the longer term, we believe investors should de-risk their portfolios and consider risk management or hedging strategies such as tail risk hedges using some combination of options, Treasuries and defensive currencies such as the yen, the US dollar and the Swiss franc.
Some of these hedges can be expensive and a robust investment process can help balance the value of the tail risk hedge against the cost. If, on the other hand, the increase in volatility is accompanied by reassurance that global growth will meet or exceed targets, then history tells us that equities should continue to rally and outperform bonds. Moreover, the right sort of increase in volatility could present a more conducive environment for stock-pickers, as stock- and sector-specific factors become more important to valuations and returns.
Inflation — cyclical or structural
While our base case for moderate, range-bound inflation remains intact in the near term, it is worth distinguishing between two types of inflation trends. One is longer term and structural and the other is shorter term and cyclical.
Structurally, inflation is likely to be contained over the long term as a result of changing demographics, insufficient productive investment to absorb current labor supply and the disintermediation of technology putting downward pressure on prices and wages.
From a cyclical standpoint, however, inflation appears to be on an upward trend. On certain measures, including the traditional consumer price inflation (CPI) index, the picture is mixed. In the US, CPI is currently close to the 2% Fed annual inflation target at 2.1%. However, an underlying inflation gauge (UIG) published by the New York Federal Reserve, which attempts to capture price fluctuations through modeling both CPI components and a range of economic and financial data, recently rose to 3% year-on-year, making market participants nervous.
Meanwhile, the Fed predicts inflation will rise over the next few months thanks to the year-on-year comparison. Last year’s inflation numbers were suppressed by temporary factors, such as a sharp fall in cellphone prices. No similar changes are anticipated this year, although inflation will likely remain constrained by other factors such as ongoing moderation in rental costs. This year-on-year effect may push core CPI above the Fed’s 2% target in April and May.
Even then, the Fed believes inflation expectations will remain anchored, despite expressing concern about the possibility of the US economy overheating. Markets, however, are bracing for an increase in real rates, suggesting they too believe inflation will pick up in the near term.
How investors might respond
In a flexible economy, a certain amount of inflation is helpful in promoting growth. However, price changes must not be too sharp or too sudden or companies and individuals may be unable to absorb the costs. Historically, when inflation has been trending higher but is not excessive, equities have done well while bonds have underperformed.
So if there is a cyclical uptick in inflation, it is worth considering maintaining a meaningful allocation to equities, while being mindful that some valuations looked overstretched prior to the recent pullback and growth will need to persist to justify further progress. As such, equities offering value, low volatility and quality should be most in demand.
Higher inflation erodes the value of fixed income, so investors may want to consider de-risking some of their bond holdings no matter whether inflation is cyclical or structural. Bond yields have already risen considerably in percentage terms from where they were last September, so if inflation readings surprise to the downside, we could see bond prices actually rally. If, however, the trend displayed by the PriceStats model continues, then it makes sense to de-risk some bond exposure or use Treasury Inflation-Protected Securities (TIPS) to counter inflation risk.
A balanced portfolio of equities and bonds can offer diversification while both asset classes remain negatively correlated. However, history tells us that when inflation shoots upwards, equities and bonds can become positively correlated and investors lose some of the diversification benefit. As yet the correlation remains benign and negative, but if that changes and growth remains solid, then investors might want to consider increasing their allocation to equities or real assets.
Commodities tend to outperform when better-than-expected economic growth leads to a negative supply shock and results in capital appreciation. While past performance is not a guide to the future, historically Real Estate Investment Trusts (REITs) have also benefited from such a backdrop, particularly when they help diversify risk in other parts of the portfolio.
Ramu Thiagarajan is global head of fixed income, currency and cash (FICC) research, State Street Global Advisors
