| By John Cavalieri and Bob Greer, Real Return Product Managers
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In the short term, the U.S. and the rest of the developed world do not have to be overly concerned about rising prices as those economies are slowing down. But economic forces are gathering over a larger, secular timeframe to generate “–flation” in the U.S. and around the world. Government response to the current financial crisis will actually add to longer-term –flationary forces. This could take the form of re-flation, in-flation, stag-flation or a combination of the three over time. (It’s unlikely to be de-flation or dis-inflation over a secular timeframe.) While these –flationary scenarios may not be desirable economic conditions, they need not be detrimental to portfolio returns. To the extent investors recognize this regime shift, they can reorient their portfolios away from asset classes that perform well in disinflation, which defined the last quarter century, and into those that are well-suited for the era of –flation going forward.
Defining “–Flations”
Knowing where we are in an economic cycle can help investors position their portfolios.
Reflation refers to a rising rate of inflation. This is not necessarily a bad thing, depending on the starting point. The U.S. rate of inflation in February 2004 was so low (core CPI was approximately 1.25%) that some observers, including central bankers, feared the U.S. might slip into deflation, which was almost universally considered to be undesirable. Japan’s “lost decade” was not what anyone wanted for the U.S. In this situation, the U.S. Federal Reserve aggressively cut short-term interest rates to 1% specifically to engineer reflation and create a cushion above deflation. Though a positive in this context, reflation can become undesirable if it leads to inflation.
Inflation, for the purposes of this paper, is an undesirable rate of price increases. While central banks of developed countries generally consider 2% to be an acceptable rate of price increases, reflation that leads to inflation above that level causes central banks to worry.
Classic inflation is usually accompanied by – or, more accurately, driven by – strong economic growth. In this case, inflation is the symptom of strong aggregate demand that is outpacing the economy’s ability to supply goods or services. However, inflation sometimes occurs during periods of low, or stagnant, economic growth. In this case, the emergence of inflation is not driven by an increase in domestic demand, but by a relative constraint on supply. Supply constraints can be driven by a variety of factors, such as exhausted capacity, depletion of resources, geopolitical conflict, trade policy or demographics. The combination of low or negative growth and rising inflation pressures creates stagflation. This economic scenario is not as easy for central banks to deal with, since policies that seek to improve one condition tend to worsen the other.
Causes of –Flation
Mainstream economic thought will ascribe –flation to easy monetary policy (low real yields on Treasuries), fiscal stimulus (fiscal deficits), or both. But there are other factors as well, including trade deficits (which can lead to a weaker currency), rising costs for labor or commodities, and shifting demographics.
In the U.S. and most other developed economies, we see fiscal deficits today.
Before recent events in the U.S., the deficit was on the increase because of the federal government’s attempts to stimulate the economy. Because so much of federal spending is for mandated entitlements whose liabilities will be increasing over time (e.g., Social Security and Medicare), it will be difficult to reduce fiscal deficits in the next several years. And now that the U.S. government will need to support large banks, mortgage-laden government-sponsored enterprises (GSEs) and other institutions, the fiscal deficit is likely to increase further.
Meanwhile, real yields on Treasuries are at the low end of their historical range, and the U.S. Federal Reserve is more likely to keep rates low than raise them at a time when economic growth is very slow. Other central banks, even if they do not have the dual mandate of the U.S. Fed, still are not likely to raise rates in pursuit of their single stated goal of curbing inflation. In emerging economies we have seen overly stimulative monetary policies, which fuel high domestic levels of growth and inflation. China, for instance, recently loosened interest rates. This is driven in some cases by their decision to peg their currency to the U.S. dollar (either fixed or managed) in order to maintain a level of currency parity with the world’s largest consumer of imports. The downside, however, is that pegging one’s currency means giving up control of domestic interest rates, which forces the emerging economy to import an overly stimulative U.S. monetary policy.
As the U.S. runs a fiscal deficit, it has also continued to import more than it exports, leading to a widening trade deficit.
This constant flow of dollars into the international economy, coupled with lower rates that those dollars earn, has caused the dollar until recently to weaken relative to other currencies. This in turn increases the cost to U.S. consumers of any goods or services purchased abroad.
Two other drivers of higher cost over a secular timeframe are labor and commodity prices. For the last several years, developed economies have relied on goods imported from emerging economies (most notably China) that have low labor costs. As those emerging economies strengthen, they are increasing their internal demand for goods and services and in the process starting to experience inflation themselves, including rising wage rates. The U.S. cannot rely forever on low Chinese labor costs to keep its own inflation under control. This is already changing.
Until this summer, we heard about rising commodity prices as well. We saw it most obviously at the gas pump, but in fact a very broad range of commodity prices increased. While there may be short-term dips, commodity prices are likely to rise over a secular timeframe. Infrastructure (supply, storage, processing, transportation) for many commodities is strained, and it will take many years and hundreds of billions of dollars for that to change. Before they provide this necessary investment, sources of capital will have to see high prices for an extended period of time, and believe that these high prices will continue. The current dip in commodity prices, however, has created uncertainty about the stable high prices needed for long-term investment. (It should be noted that the price declines resulted not from increased supply, but from reduced demand expectations due to the slowing economy.) Meanwhile, demand for energy in the short run is fairly inelastic, and demand for food is inelastic in both the short and long run. There is no action that central banks can take to provide the world any more oil, wheat or coffee. And the traditional solution to inflation, which entails slowing the U.S. economy, does little to reduce demand for energy and food, especially since these prices are driven by global, not local, supply and demand. Fed policy, at least, can reduce demand for “infrastructure” commodities such as industrial metals. But these infrastructure commodities are less important in most measures of consumer inflation. Fed policy may also reduce demand at the margin for other commodities should it sufficiently slow the world’s largest economy, but that is akin to using a very blunt tool to address a delicate, specific problem.
Finally, demographics over the next several years and beyond will have an impact on –flation. The obvious demographic factor is that as U.S. baby boomers retire, Social Security and Medicare payments will increase, exacerbating fiscal deficits. But there is a more subtle demographic factor to consider as well: as the average age of a population increases, there will be fewer productive workers compared to retired people. Each productive worker has to provide goods and services for her- or himself and for an increasing proportion of retirees. For instance, in the U.S. at the moment there are about five active workers (ages 20–65) producing goods and services for themselves and for one person over 65. Based on current demographics, within 15 years there will be only three active workers for every person over 65. Similar demographics exist in many other developed countries. Even if retirees have the money to pay for these goods and services, this shift in supply and demand is likely to drive up prices of those goods and services.
The persistence of inflation on a global basis is evident in the comparison of actual inflation to target inflation around the world. Economies around the world are not hitting their targets, as shown in Figure 7.
–FLATION IS GOING TO REPRESENT AN INVESTMENT CHALLENGE
Investment Implications
Critical to achieving a successful investment outcome are two key steps: 1) recognizing the underlying macroeconomic environment that is likely to define the investment horizon, and 2) aligning a strategic asset allocation accordingly. Specifically, investors should consider two fundamental macroeconomic variables – real economic growth and inflation – and further consider two possible states for each – high/rising or low/falling. This simple 2×2 matrix provides an intuitive framework for identifying the four basic states of an economy.
Once investors identify the most likely current and forthcoming states of an economy, they can then construct a portfolio that emphasizes assets that are likely to perform best in those states.
With this framework it becomes clear that the simple stock-bond mix that has come to define a “core” or “balanced” allocation falls short of diversifying investors across the four possible macroeconomic states. Specifically, the stock-bond mix only makes sense in a low or disinflationary world, and only if the investor has ruled out the possibility of a handoff to higher inflation. Given PIMCO’s secular outlook, which explicitly calls for a regime shift to a world of rising inflationary pressures, this allocation approach is not optimal.
This forces a simple question: Why would the broad investment community allow such a glaring omission in a strategic asset allocation?
The answer appears to be driven by the shared and rather homogenous disinflationary experience of today’s investment community. Specifically, for the last quarter century, developed economies have experienced a virtually uninterrupted period of disinflation. Beginning in the early ‘80s, inflation has steadily declined in developed economies from the teens to the “Goldilocks” level of 2%–3%. Since inflation was in secular decline, the only economic variable in play on our 2×2 matrix was the level of real growth. Therefore, it made perfect sense for investors to focus on stocks and nominal bonds within their core portfolio, since they only needed to be diversified with respect to the level of real growth in a disinflationary context.
What made perfect sense in the rear-view mirror makes less sense when looking through the windshield and seeing a future more likely to be defined by rising inflation than falling inflation. What does this mean for investors? In our view, a few themes are clear:
- The traditional stock-bond mix does not properly align investors’ strategic holdings with secular macroeconomic forces. At a minimum, we feel this calls for increasing exposure to real assets, notably commodities and inflation-linked bonds (ILBs).
- In a world in which inflation risk is to the upside, fixed-rate Treasury bonds should no longer be viewed as the “risk-free”* asset. Rather, ILBs assume that role, since they uniquely help protect investors from inflation risk given their CPI-linked payments. (Of course, if ILBs are not held to maturity, they may underperform just as any other fixed income security that is subject to interest rate risk.)
- Within the “low real growth” half of the matrix that is typically centered on bonds, investors should consider separating their desired “spread risk” exposures from the underlying Treasury/ILB exposure. In other words, bonds can be disaggregated into various risk components. For instance, a corporate bond may be disaggregated into a Treasury bond + swap spread + issuer credit spread. In a world in which ILBs replace Treasuries as the “risk-free”* holding, investors should look for strategies that allow them to “port” their desired spread risk exposures on top of their desired Treasury/ILB mix and not be saddled with the disinflationary bias embedded in traditional fixed-rate spread sectors.
- Within the “high real growth” half of the matrix that is typically centered on stocks, we believe investors should diversify into commodities. Since commodity futures may perform well in a global macroeconomic environment characterized by strong global growth and constrained input supply, a commodity allocation can diversify the risk of equity underperformance amid supply-driven inflationary pressures. Plus, investors may benefit from the fundamental diversification benefits that a commodities allocation brings to a total portfolio, and from the fact that a commodities allocation allows investors to “cover their short position” with respect to future needs to consume commodities (i.e., food and energy) that they don’t own today.
- As growth declines (perhaps due to a monetary authority reacting to high inflation), we could see stagflation, in which case ILBs might still outperform nominal bonds due to high inflation accruals. Assuming the stagflation is caused by a constrained supply of food and energy, then pressure from the monetary authority may not be highly effective, since it can scarcely shift the highly inelastic demand for those goods.
- No economy is likely to remain in just one investment quadrant. Investors must always expect change and consider how it will affect their portfolios.
Conclusion
Economies, at varying speeds, will be moving from an era of disinflation to a –flation regime. And that –flation regime will not be static. An awareness of the investment implications of changing states of –flation can help investors to control their portfolio risks and achieve desired returns.
John Cavalieri, Real Return Product Manager
Bob Greer, Real Return Product Manager
November 2008
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