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Opening Up the Inflation Playbook… Again

What strategies can be implemented to mitigate – or in some cases, harness – the impacts of inflation on a portfolio. Matthew Bartolini takes a look in his latest post.

Head of SPDR Americas Research

Inflation has spent more time below 2% than above it over the past 10 years,1  yet we are often asked what strategies can be implemented to mitigate – or in some cases, harness – the impacts of inflation on a portfolio. And now the calls for an inflationary playbook have indeed grown louder considering that:

  • Treasury Inflation-Protected Securities (TIPS) outperforming nominal Treasuries for five consecutive months to register a cumulative outperformance of 6.1% since the end of March; 
  • CPI rebounding off April lows for the past three months and; 
  • Breakeven rates rallying from 0.47% to 1.66% since March

We spoke about the prospects for inflationary pressures in our Q1 Bond Compass as well as in our Midyear Outlook, largely focusing on the relative value role TIPS could play in a portfolio. But there are more tactics in the inflationary playbook that can be called upon, given that:

  • A dovish Federal Reserve has expanded its balance sheet from 19% of GDP at the start of the year to 33%, and they continue to purchase individual bonds and other financial instruments 
  • Fiscal stimulus has increased the deficit to -15% of GDP from -4.7% at the start of the year, with more spending likely, with Treasury issuance funding the current and the potential next round of stimulus

These emerging catalysts may provide extra inflationary tailwinds:

  • Both US presidential campaigns’ policy frameworks call for increased spending – albeit with different spending benefactors 
  • After a yearlong listening tour on a review of its policies, the Federal Reserve may relax its preference for a 2% inflation threshold,2  indicating that the Fed could let inflation run higher than the 2% under a recovery scenario

The inflation playbook

There are two types of plays in this playbook: offense and defense. For the latter, this means seeking out exposures that may mitigate the impacts of inflation’s erosion of principal. The former represents exposures that may benefit from a higher inflationary regime as a result of firm operating profiles and revenue-generation potential.

For inflation mitigation, the first strategy would be to consider selling nominal Treasury exposure for TIPS. The thesis here is that the current policy response is similar to the one that was implemented during the GFC crisis — and post-GFC TIPS began to outpace nominal US Treasuries. From mid-2009 through 2012, TIPS outperformed nominals in 60% of the months by an average of 30 basis points.3 Outside of any ability to go long/short, swapping nominal exposure for TIPS may be an efficient way to capture this premium – either completely or through a blend (i.e., 50%/50%). Adding TIPS without reducing nominal exposure will unintentionally extend a portfolio’s duration profile and dilute the potential relative value opportunity, as duration effects will be the predominant driver of risk and return of this trade. After all, TIPS are still bonds.

To customize duration, consider:

  • SPDR S&P Portfolio TIPS ETF [SPIP
  • SPDR Bloomberg Barclays 1-10 Year TIPS ETF [TIPX]

Gold is another often discussed potential inflation mitigator. However, the timeframe is important for gold. Gold may mitigate the effects of inflation over a long time period, as a result of its potential as a store of value and its ability to keep up with price fluctuations in conjunction with currency depreciation over the long run – one reason why we continue to discuss its strategic role in portfolios . In the short-term, however, other macro factors (rates, dollar) could impact the spot price irrespective of inflation in isolation. Right now, however, given that higher inflation is occurring with no movement in nominal yields, real yields have fallen, and that has been a benefit to the spot price – and real rates have historically been a strong driver in the short-to-medium term for gold.

Hot routes for inflation
Harnessing the impacts of inflation largely falls to examining equity exposures containing firms with commodity-related operations. As shown below, across the 11 GICS sectors, three of the top four segments with the highest sensitivity to breakeven inflation rates have business lines related to natural resources. Financials have the second-highest sensitivity, given the historical impact inflation has on interest rates and the high sensitivity financials have toward rates. With respect to commodity- related areas, higher inflation may lead to higher commodity prices, while also coinciding with an uptick in demand for natural resources as a result of one of the catalysts of inflation being increased spending. That uptick in demand may further increase the underlying commodity prices, potentially generating higher profits for those natural resource companies, which may then translate into higher returns.

Source: Bloomberg Finance L.P., as of 08/17/2020 based on stock returns for the S&P 500 GICS sectors versus 10-Year Breakeven Inflation Rates from 08/2015 with weekly granularity. 

Targeting the more specific segments of natural resource producers while also broadening the scope to include mid- and small-cap firms is likely to improve a portfolio’s sensitivity to inflation. Going further down the cap spectrum also leads to obtaining exposure to firms with potentially higher sensitivity than that of large-cap firms. This is due to their business operations being less diversified than those of larger firms — and therefore, likely more reliant on the spot price of a commodity. Smaller firms also have a tendency to have higher leverage ratios. This is evident in the chart below, which examines the average beta sensitivity to breakeven rates of the firms within the S&P Metals & Mining Select Industry Index – a targeted segment of the Materials sector. An equal-weighted approach to industry investing may allow investors to harness the higher sensitivity without shouldering excessive single-stock risk.  

Source: Bloomberg Finance L.P., as of 08/17/2020 based on stock returns for the S&P Metals & Mining Select Industry Index broken out by market cap definitions versus 10-Year Breakeven Inflation Rates from 08/2015 with weekly granularity. 

When running the same five-year beta sensitivity for more granular industries, as well as targeted resource producers, the sensitivity for those narrower segments increased above broader sectors as a result of the forces discussed earlier. As a result, for investors seeking to play offense with inflation, focusing on some of these segments may be beneficial.

Source: Bloomberg Finance L.P., as of 08/17/2020 based on stock returns for the S&P Oil & Gas Equipment Services Select Industry Index, S&P Oil & Gas Exploration & Production Select Industry Index, S&P Metals & Mining Select Industry Index, S&P Regional Bank Select Industry Index, S&P Bank Select Industry Index, S&P Homebuilders Select Industry Index, S&P Aerospace & Defense Select Industry Index, S&P Transportation Select Industry Index, S&P Global Natural Resources Index, and S&P North American Natural Resources Index versus 10-Year Breakeven Inflation Rates from 08/2015 with weekly granularity. 

To pare back core allocations and add inflation satellites, consider:

  • SPDR S&P Oil & Gas Equipment & Services ETF [XES]
  • SPDR S&P Oil & Gas Exploration & Production ETF [XOP]
  • SPDR S&P Metals & Mining ETF [XME]
  • SPDR S&P Global Natural Resources ETF [GNR]

Stylistic decisions

Style exposures can have inflationary relationships. As shown below, small-cap and value-oriented strategies have had the stronger sensitivity over the past five years. Value’s metrics relative to growth are indeed higher at each cap spectrum. This makes sense, to a degree, as higher inflation typically coincides with higher economic growth and, therefore, higher bond yields — both of which have a strong connection with cyclically oriented value and small-cap exposures. Similarly, inflation can be problematic for growth investing. Growth investing translates into paying X for Y amount of growth and if inflation meaningfully increases, the value of that future growth that you are paying an elevated X for today is then reduced.

Source: Bloomberg Finance L.P., as of 08/17/2020 based on stock returns for the mentioned style indices versus 10-Year Breakeven Inflation Rates from 08/2015 with weekly granularity. 

Overweighting value, mid caps and small caps may be the play, depending on your investment thesis for inflation alongside a full-blown recovery. However, our current recovery is marked by transcendent and generation-defining socioeconomic shifts taking place as we adjust to a new digitally connected but physically separate world. Those shifts are likely to continue as our daily routines change, and they are likely to be driven by firms within certain sectors (Technology, Consumer Discretionary, and Communication Services) that are well represented in traditional growth exposures. Therefore, the historical uplift of inflation for value relative to growth may not be as strong as a result, leading to growth likely still outpacing value in the near term. Targeted sector and industry exposures, therefore, may be the more ideal inflationary offensive play call.

Opening the inflation playbook

We’ve dusted off the inflation playbook a handful of times over the past few years, most notably following the 2016 US presidential election, when hopes of infrastructure spending and lower taxes fueled a reflation trade. That was a bit short-lived, and running the playbook was akin to Charlie Brown trusting Lucy with the football again. This time, perhaps Charlie “Inflation” Brown will make contact with the pigskin and offensive and defensive inflationary play calls can add value to a portfolio. The four catalysts identified above are likely to help, as will any positive health news that leads to the global economy recovering more quickly.

For more insights on the current market, stay tuned to the SPDR Blog.