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How to Factor Inflation into Your Portfolio

  • Inflation continues to rise as supply side activity remains congested and commodity price increase.
  • To prepare for an inflationary regime investors consider sectors and asset classes that can support their portfolio. 
  • Two areas of interest include real assets such as real estate and multi factor investment strategies. 

After years of inflation levels below 2%, financial markets are pricing in a post-COVID economic recovery and the potential for “reflation” in the second half of 2021 and beyond.

Central banks contend that inflation is a “transitory” phenomenon, a view State Street Global Advisors shares. However, inflation risks have undoubtedly increased. Over the last 40 years inflation has been generally contained within or below the targets set by central banks but recent signs point to higher levels of inflation around the world. Central banks themselves have been preparing for higher inflation levels by changing the language they use, which over the last year has shifted from inflation targets to inflation “averaging”, a clear indication that they are willing to see inflation run temporarily hot to allow for room for the global recovery from the COVID induced slowdown. And in their latest statement, the Fed’s inflation forecast for 2021 increased from 2.4% to 3.4%.

Markets are also reflecting signs that they expect higher levels of inflation. Signs include: 

1. Increasing bond market yields. Over the last year bond yields have increased. This reflects the fixed income markets expectations around future growth and inflation. Yields reflect a measure of the cost of capital, as investors purchasing power is eroded by higher inflation they will demand higher yields to be compensated for the inflation risks they see on the horizon. Specifically over the last year, yields in both the United States (US) and Australia have increased between 60-80 basis points. 

Source: Bloomberg Finance L.P., as at 30 June 2021.

Although yields are higher than a year ago, they have tempered more recently as bond markets digest the hardened stance that central banks have taken around inflation being transitory and currently not seeing any need to bring rate hikes forward. A view not necessarily shared by the market.

2. Breakeven rates. Breakeven rates are calculated as the difference between treasury rates and treasury inflation-indexed security rates. Market participants use this value as a proxy for expected inflation, where 5 year breakevens reflecting what the market expects inflation to be in the next 5 years. The US 5 year breakeven rate peaked mid-May 2021 at just under 2.8% and even today lies around 2.5%, above the average target set by the Fed of 2%.

Source: Bloomberg Finance L.P., as of the 30 June 2021

3. Change in commodity pricing. Commodities are  regarded  an inflation indicator and an inflation hedge. We have seen a rapid rise in the price of commodities over the last 12 months, with commodity prices across the board rising to the highest levels since the start of the pandemic. In part, the near 100% increase in commodity prices is a reflection of the low base level commodity prices reached at the start of the pandemic but absolute price levels in many cases have surpassed pre-pandemic levels. The increased price for raw materials will eventually feed through to consumer in the form of higher prices for final goods.

Source: Bloomberg Finance L.P., *World Bank, as of 30th June 2021

**Bureau of Labor Statistics, as of 28th May 2021

The New Inflationary Regime Favours a Balanced Factor Approach

Investors may want to look at traditional inflation hedge assets such as real assets, including property. To gain exposure to property investors may include the SPDR® S&P®/ASX 200 Listed Property Fund (SLF) and SPDR® Dow Jones Global Real Estate Fund (DJRE) in their portfolios. Both options can provide additional diversification and inflation hedging characteristics. 

With equities typically being the largest allocation in an investor’s portfolio, and the largest source of risk, investors may consider a balanced multi factor strategy such as the SPDR® MSCI World Quality Mix Fund (QMIX). As shown below, based on the average quarterly return in inflationary regimes, factors such as Quality, Value and Low Volatility may outperform the broad market index.

Source: State Street Global Advisors, Bloomberg Finance L.P., MSCI, from 30 June 1988 to 31 March 2021. Past performance is not a reliable indicator of future performance. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income as applicable.

As inflation pick ups, we also expect to see more volatility across markets as well as a potential for further rotation from growth to value which we have already seen this year. With this backdrop a strategy like QMIX can help to provide investors with exposure to the different factors driving markets. The inclusion of low volatility within the factor mix should help weather through any spikes in volatility we see. Therefore, allocating to QMIX rather than a broad market index should support the State Street ETF Risk-Based ETF Model Portfolios in inflationary regimes. 

The higher prices for raw materials will probably result in temporary inflation pressures and we expect to see inflation settle slightly higher than investors may be anticipating. Further, the unwinding of the supply side bottlenecks may take some time and despite a pick up in manufacturing, shipping is still in a back log phase. As these supply side bottlenecks unwind, we expect inflation should settle, until then investors are encourage to think about strategies that will support their portfolios in reflationary regimes