Don’t worry about inflation, but do prepare for it

Portfolio managers debate the best way to hedge inflation risk while also downplaying the likelihood of rising prices.

While panelists batted around the concept of inflation during a discussion Thursday at the Morningstar Investment Conference, the general message was that while advisers and investors shouldn’t worry too much about rising prices, they should brace portfolios for the possibility of such inflationary pressures.

“Inflation should always be considered; as we invest, inflation is one of the core risks we’re underwriting,” said Catherine LeGraw, asset allocation specialist at GMO.

Despite clear signs of higher prices, the panelists, like most market watchers these days, are taking the spiking consumer price index mostly with a grain of salt that enables them to subscribe to government statements about inflation being “transitory.”

“There have been a variety of one-off factors and one-off price level moves,” said Nic Johnson, managing director at Pimco.

“As people start to get out and things reopen, we’re seeing general reopening inflation pressures,” Johnson said. “Inflation has clearly spiked, but how much will it normalize back to the Fed’s target and … how much will be more permanent?”

The answer to that question is typically found in wages, because once wages start to climb, inflation becomes more difficult to fight. On that note, LeGraw questioned whether workers have enough leverage to drive wage increases.

“Worker power is quite low relative to history,” she said. “We feel skeptical that wages will run out of control and inflation will take off. That said, our portfolios are positioned for inflation.”

Asked about the federal government’s role in fueling inflation, LeGraw acknowledged that “both fiscal and monetary decisions have caused more money to be out there in the economy,” which leads to more money chasing fewer goods and services.

“You have to believe [the federal government] had something to do with it,” she said. “But it looks like any excess has been pushed into the stock market, and not goods and services.”

Evan Rudy, portfolio manager at DWS, agreed that current inflation data reflect basic supply and demand factors.

“If the economy starts to reopen, globally we could see some inflation issues,” he said.

Johnson compared the current economy to runners bunched up at the start of a marathon.

“As it goes on, we start to spread out, and you find your own pace and we get a lot more space,” he said. “Right now, there’s demand for goods and services, and there are logistical issues. I think you’ll see an improvement as vaccination rates go up and density rates increase. I think something will happen naturally and it will probably look like the inverse of the CPI numbers.”

In the meantime, to hedge bets, the panelists advise treading lightly into certain sectors of the financial markets.

“The beautiful thing about equities is they are real assets, but the problem with equities is oftentimes you see a re-rating,” said LeGraw, who advised, “Buy the cheaper stocks because they are less vulnerable to re-rating.”

Even with modest negative inflation beta, Johnson agreed the benefits of profit generation give a nod to equities. However, the panel said the real hedges are found in natural resource equities, commodities and real estate.

“You’re earning the long-term risk premium with natural resource equities,” said LeGraw. “The last few years commodity futures have been plagued by negative roll yield.”

But even with the challenges that come with commodities futures, Johnson said any big move into natural resource equities could overload portfolios that are likely already equity-heavy.

“We think a lot of investors already have a high degree of equity beta,” he said.

In terms of gold as an inflation hedge, Johnson said, “The best way to think about gold is for a very, very long-duration real asset. The price will keep pace with inflation over a very long period of time.”

The key, he added, is the “intersection of inflation and real yield.”

“If inflation goes up and real yields go up, I would expect gold to not be a good inflation hedge,” Johnson added. “Gold is not at its highs, and we think gold is cheap relative to TIPs and government bonds. But remember, this is a very long duration asset, so anytime you add to it, you’re adding duration to your portfolio.”