Investing for Higher Inflation
Board: Macro Economics
Active debate continues on the future path of the US economy. One side, with the Federal Reserve strongly in their corner fears zero or lower inflation, aka deflation. The reason to fear deflation is that it can turn into a death spiral that is difficult to recover from. Ben Bernanke’s famous “helicopter” speech back in 2002 was entitled “Deflation: Making Sure “It” Doesn’t Happen Here.” (1) The speech was a precursor to many of the actions that the Fed has taken since the credit crash.
On the opposite side are investors that think the US is headed for “higher” inflation. The range of higher inflation varies greatly. For example Ken Rogoff, co-author of “This Time is Different” has called for the Fed to work towards a target of ~ 4-6% inflation.(2) Other investors including some METARites fear even higher inflation, bordering on hyperinflation.
This post will not add anything to the deflation versus inflation debate. If you are solidly in the deflation ad infinitem camp, you might as well skip this point. This post is intended for those in the higher inflation camp. Last year, TMF Morgan Housel had a post entitled: “The Other Side of Inflation” (3) which argued:
Inflation, of course, raises prices, which is bad -- and that's usually where the criticism ends.
But there's another side of inflation: the impact it has on wages and assets. If prices go up 10%, but wages and net worth also rise 10% (or more), are you worse off?”
I posted in reply: “Why you should FEAR inflation.” (4) My main point was that equities and fixed income would suffer poor returns if inflation increased. Since then, Rob Arnott of Research Affiliates has chimed in with his concerns that equities and fixed income will suffer in an increased inflation environment.(5) In my post last year, I did NOT address how to invest if you expected increased inflation.
This week John West from Research Affiliates published: “The Newlywed’s Dilemma” that specifically addressed how to invest for increased inflation. Rob and Research Affiliates are very adamant that traditional portfolios with traditional equities and fixed income are NOT well equipped if and when inflation picks up. They advocate adding a “Third Pillar” that will perform better with higher inflation. The asset classes they specifically recommend are:
Emerging market debt
High yield aka junk bonds
The paper talks about having a 20% to 50% allocation to these new asset classes. I have previously heard Rob recommend having a 33% allocation. The paper presents back test results showing how each of these asset classes has performed including volatility. The paper has a lot of different facts, so I am not going to try and include them here. It discuses “low volatility portfolios”, “Optimized Strategies” versus “Heuristic Strategies” and several other obscure points. If you are interested, I recommend you read the paper.
The paper does NOT mention this, but I do know that Rob manages the Pimco All Asset Fund aka PAAIX. It is specifically geared to be the “Third Pillar” that performs well under high inflation. If you do not want to roll your own inflation fighting portfolio, you might consider making a single investment decision by adding an allocation to this fund. There might be other funds that have similar goals, but I have not researched them.
BOTTOM LINE is that IF you think the US is headed for increasing and/or high inflation, a traditional portfolio of stocks and bonds will not perform well. You need additional asset classes in significant proportions.
(1) Ben Bernanke speech: “Deflation: Making Sure “It” Doesn’t Happen Here.”
(2) Ken Rogoff: “The Second Great Contraction”
(3) TMF Morgan Housel: “The Other Side of Inflation”
(4) Yodaorange: “Why you should FEAR inflation”
(5) Jason Hsu: “The 3-D Hurricane and the New Normal”
(6) John West, “The_Newlyweds_Dilemma”