Industry Voice: Many investment portfolios that rely heavily on stock-bond diversification to manage risks may not be protected against inflation surprises. Real assets offer a solution.
Inflation in the U.S. has accelerated from near zero in 2015 to 2.5% in 2018 (according to the Consumer Price Index or CPI), propelled by trade tensions, strong consumer spending, the tight labor market, and a boost in growth from tax reform and other fiscal stimulus. After so many years of low inflation, the rise in 2018 points to the possibility of an inflation surprise.
Such a surprise could be damaging because many investors may be too reliant on diversification achieved by investing in a portfolio of stocks and bonds, which is predicated on the historical negative correlation between the two asset classes. However, this diversification may not work as well going forward because correlation between stocks and bonds tends to rise when inflation is elevated (see Figure 1).
Therefore, we suggest investors consider real assets (so called "inflation fighters") to make portfolio diversification more robust and hedge against the risk of higher inflation. These include TIPS (U.S. Treasury Inflation-Protected Securities) or other sovereign inflation-linked bonds (ILBs), commodities, REITs (real estate investment trusts) and multi-real asset portfolios, all of which have the potential to perform better during times of rising inflation.
To learn more about these four potential inflation-hedging solutions, read the full version of "Preparing Portfolios for Resilience Against Inflation Surprises".
DISCLOSURES
Past performance is not a guarantee or a reliable indicator of future results.
All investments contain risk and may lose value. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government. REITs are subject to risk, such as poor performance by the manager, adverse changes to tax laws or failure to qualify for tax-free pass-through of income. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. The use of leverage may cause a portfolio to liquidate positions when it may not be advantageous to do so to satisfy its obligations or to meet segregation requirements. Leverage, including borrowing, may cause a portfolio to be more volatile than if the portfolio had not been leveraged. Derivatives and commodity-linked derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Commodity-linked derivative instruments may involve additional costs and risks such as changes in commodity index volatility or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Investing in derivatives could lose more than the amount invested. Swaps are a type of derivative; swaps are increasingly subject to central clearing and exchange-trading. Swaps that are not centrally cleared and exchange-traded may be less liquid than exchange-traded instruments. Diversification does not ensure against loss.
Hypothetical and simulated examples have many inherent limitations and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated results and the actual results. There are numerous factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results. No guarantee is being made that the stated results will be achieved.
Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown.
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