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.
The views expressed in this material are the views of SPDR State Street ETFs through the period ended 30 September 2021 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
Equity securities may fluctuate in value in response to the activities of individual companies and general market and economic conditions.
A Smart Beta strategy does not seek to replicate the performance of a specified cap-weighted index and as such may underperform such an index. The factors to which a Smart Beta strategy seeks to deliver exposure may themselves undergo cyclical performance. As such, a Smart Beta strategy may underperform the market or other Smart Beta strategies exposed to similar or other targeted factors.
A “low volatility” style of investing can exhibit relative low volatility and excess returns compared to the Index over the long term; both portfolio investments and returns may differ from those of the Index. The fund may not experience lower volatility or provide returns in excess of the Index and may provide lower returns in periods of a rapidly rising market.
A "quality" style of investing emphasizes companies with high returns, stable earnings, and low financial leverage. This style of investing is subject to the risk that the past performance of these companies does not continue or that the returns on "quality" equity securities are less than returns on other styles of investing or the overall stock market.
A “value” style of investing that emphasizes undervalued companies with characteristics for improved valuations, which may never improve and may actually have lower returns than other styles of investing or the overall stock market.
Real Estate Investment Trusts (REITS) investing may be subject to risks including, but not limited to, declines in the value of real estate, risks related to general economic conditions, changes in the value of the underlying property owned by the trust and defaults by borrowers.
Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
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