How Will The State Street ETF Model Portfolios Weather Inflation?

  • Inflation has been moving higher creating increased angst for investors.
  • Central banks maintain this is a transitory effect and will not be a long term persistent trend but investors should be wary that inflation could remain stubbornly higher before retreating.
  • The State Street ETF Model Portfolios are designed to weather different market environments, including inflationary ones.

One of the essential debates is whether inflation will be sustained or just
transitory. Consumer price inflation is surging globally and an intense debate
is raging as to whether this is merely a transient phenomenon reflecting abnormally low base effects or something of a more lasting nature. The United States Federal Reserve (Fed) and other central bank policymakers have little doubt that costs for many goods and services will jump, but they do not expect this to be a long-term persistent trend. Rather they attribute this as a one-off as the economy recovers from the pandemic and not the start of a more persistent inflation problem. 

US CPI YoY Index

We are broadly in agreement and expect the rise in inflation to be temporary, but there are a number of risks investors should consider. Despite being transitory, it could be more prolonged than many investors anticipate. Markets are also reflecting signs that they are expecting higher levels of inflation and that central banks may be forced into action in relation to interest rates sooner than they themselves are indicating.

Constructed to Navigate Different Market Environments

The State Street ETF Model portfolios are built to be able to navigate different market environments. An inflationary environment, coupled with the low interest rates and yields that are being anchored by central banks creates a range of challenges for multi asset investors. These issues are increasingly spanning across the whole of the portfolio and not restricted to any single asset class. 

Equity allocations face a number of headwinds during inflationary periods but analysis demonstrates that smart beta factors may serve investors well. Not only can investors harvest the factor premia’s over the long term but factors such as quality, minimum volatility and value, all have done well historically in inflationary regimes. The State Street ETF Model Portfolios gain exposure to each of these factors through the SPDR® MSCI World Quality Mix Fund (QMIX). Real assets such as property and REITs are also thought of as inflation hedged and can be attractive given the stable income they can provide. However, the performance of REITs can be mixed across inflation regimes. While total return expectations are in line with equities, REITs have higher levels of forecasted risk, therefore their role in a portfolio needs to be carefully considered. One of the considerations is that they have a higher beta to equities than some other potential diversifiers. The market risks that this asset class is exposed to is similar to equities. For this reason that the State Street ETF Model Portfolios do not have an explicit allocation to domestic or international REITs, although there is some exposure to this sector through the equity ETFs that the models invest in. 

The fixed income components of multi asset portfolios would usually provide a hedge to the equity risk of a portfolio but traditional defensive assets are facing a number of hurdles in the current environment. With current levels of yield near historical lows, there is very little room for them to be able to move substantially lower. This is exactly what investors would look for yields to do, to provide a hedge to the risky assets in their portfolio. Yields are marginally more appealing in Australian and the US which is why the State Street ETF Model Portfolios invest in both Australian government bonds and Australian credit. Australian government bonds maintain an attractive yield spread when compared to global bonds, specificallym European and Japanese government bonds. The models also target credit exposures that have a positive yield spread to treasuries with generally lower duration which is attractive in the current environment of interest rate uncertainty.

While expectations are that the higher inflationary environment we are witnessing should be transitory, we still might see inflation remain stubbornly higher for longer than most investors are anticipating. The potential inflationary pressures, coupled with the continued narrative from both domestic and international central banks that thy do not expect to raise rates in the immediate future, suggest investors have a number of tests ahead of ahead of them. Every inflationary period has different drivers behind them which will dictate how assets perform, but we believe the State Street ETF Model Portfolios are well positioned to help investors navigate these tests.