Taking Away the Punch Bowl

The potential outcome of inflation rising faster than expected

Originally published in the September 2017 issue

Large-scale, continuous, and at least somewhat coordinated, fiscal and monetary responses from governments and central banks around the world have changed the landscape of markets and the pricing of assets. Like an open-minded and overtly obliging doctor, the Fed has been doling out prescriptions of reduced fear and enhanced greed to anyone needing a fix. Driven by investor feelings of bravado from being handed a free put option and expectations of a new normal (low interest rates for the indefinite future), most measures of market value have skyrocketed to all-time highs as speculators have demonstrated disregard to the quality of earnings or credit. Interest rates have been kept at rock-bottom levels, while quantitative easing, once little more than a footnote in textbooks, has become a common monetary policy mechanism that the market has, at least implicitly, taken for granted. Now investors scratch their heads as they ponder the implications of tighter monetary policy as the Fed heralds the “long march to normal” as they “embark on the great unwinding”. Call it what you will, but note with near certainty that this is the beginning of the end of easy money. The market, if weaned gradually, may traverse a non-traumatic transition to a not-so-new new normal. But it just may be that the Fed, in the famous words of William Martin, its longest serving Chairman, is abruptly fulfilling its duty “to take away the punch bowl just as the party gets going”. If so, the hangover comes next.

Owing to tell-tale signs of diminished slack in the economy and broad economic recovery, central banks increasingly feel that they can (or must) rip off the proverbial band-aid. And, when focusing on employment, inflation and the overall ease of financial conditions, there is increasing evidence that they are right to do so. Low unemployment rates in both the United States and the United Kingdom indicate labour markets are reaching their natural limit. Joblessness in the UK, similar to that of the US, has steadily dropped to 4.3%, its lowest rate since the mid-1970s. Meanwhile, the UK’s employment rate of over 75% marks a new all-time high. The Euro area, too, though more bifurcated from North to South, is generally experiencing improved employment levels. As to inflation, some officials in the US find themselves in a quandary as to the stubbornly restrained price rises. But outspoken hawks, like former US Congressmen Ron Paul, warn not to be surprised “when we witness 1970s-like consumer price spikes”. Though many dismiss Mr. Paul’s remarks as sensationalist, central bank speak suggests higher than expected inflation may be coming, with several Governors alluding to concerns that they are on the back foot containing it. UK inflation, for example, recently steady at 2.6% has now been gauged closer to 3%, reigniting hopes (at least by some) of a sooner than expected UK rate hike to stave off rising inflation. After the latest UK inflation print, the September Bank of England minutes are telling. The statement explicitly shows the concern central bankers have over forward-looking inflation and indicates future policy stance. Markets are now pricing in an 80% chance of BOE activity in months to come. In the US, the Fed has already hiked twice this year, and have indicated their intentions of a third raise in December with more to come as needed in 2018. “Don’t fight the Fed,” without doubt, has been a prudent investing maxim over the past nine years.

It has been a mistake to expect that the party would last forever. Inflation, nonetheless, until recently has been absent from investor worries despite central bankers collaborating openly, innovatively and incessantly, to create it. The inevitable manufacture of inflation could rise far more rapidly than expected and perhaps has already begun its ascent. Investors now must grapple with how best to protect themselves against it. While few, probably rightly so, imagine a return to the double-digit inflation of the 1970s, it’s not too much of a stretch to imagine scenarios where inflation breaks through general targets of 2-2.5% and reaches 4-5% in the coming years. Modestly rising inflation and interest rates, up to a certain point, can be bullish for equities. Somewhat higher inflation, however, could be troublesome for credit and fixed income holdings. Much higher inflation would be calamitous. If inflation builds, front-end rates will be pushed higher. Aside from asymmetric losses on large sovereign bond portfolios, technical problems could arise through collateral requirements for corporates, particularly large insurance companies, that utilise money markets. Furthermore, high-yield investors and courageous treasure hunters who have sought greater yield in lesser and more exotic credits are particularly exposed. They had best don helmets when those corporates come to refinance – now may be the time to be fearful, not greedy.

Extreme correlation across most asset classes over recent years lends credence to the argument that allocation between stock and bonds, spread across geographies and sectors, is insufficient for prudent portfolio diversity. Although there does exist a range of non-correlated, or even inversely linked, alternative investment strategies that can be profitable while helping preserve portfolio value in turbulent times, allocators have been reluctant to deploy them as of late. And, given the nearly one-way rise of most markets since March 2009, investors have been rewarded for their abstinence as traditional hedging strategies have been a heavy drag on portfolios. According to Matt Elstrop, a Senior Analyst that constructs bespoke portfolios at International Asset Management, “long volatility strategies have suffered due to persistent volatility compression, while trend following strategies might not exhibit their historical defensive characteristic if they have to pay the carry to be short interest rates.” Whilst uncorrelated, idiosyncratic opportunities that extract alpha remain, these are hard to find and not always scalable. For example, “it is possible to buy positive carry protection through forward starting volatility agreements due to upward sloping rate volatility curves, but these strategies are capacity constrained,” says Elstrop.

Moving from Wall Street to Main Street
Another historically effective way to diversify risk, and hedge against inflation, is through exposure to real assets – real estate, commodities and infrastructure – that tend to perform better than commonly held stocks and bonds during inflationary periods. But many investors are reticent. Whilst real assets tend to climb during periods of rising inflation that destabilize traditional portfolio gains, many have long been underappreciated by investors. And, in part, with good reason. Typical gripes are of poor liquidity, instability due to exogenous events, and unpredictability of returns. Further, natural barriers of entry to some of the most lucrative real asset investments, reserved for only the largest players that cut big checks, have political relationships and an appetite for indefinite lock-in periods, had logistically barred some investors altogether.

The trepidation of allocating to real assets has been abating as investors look to them in search of both yield and portfolio protection. And there is a luring sweetener – the relative price of real assets to financial assets is at its lowest level in nearly 100 years. Mega asset managers have already picked up the scent, and there may be good reason to expect some impetus towards mean reversion. BAML has advised that “it’s time to get out of financial assets and into real things,” urging clients to shift some portfolio assets from “Wall Street to Main Street.” The likes of BlackRock, Morgan Stanley and TIAA Global Asset Management are committing resources to the opportunity, having recently created new business units to focus on investing in real assets. Even bond giant, PIMCO, is currently promoting an overweight of real assets in its 2017 allocation outlook report. This shift into real assets requires innovation and a new way of thinking. Inflows of capital from sovereign wealth funds, insurance companies and pension funds have already surged into infrastructure and real estate in search of yield and to benefit from historically low interest rates. Sovereign wealth funds, particularly, have made large infrastructure investments owing to their vast and swelling assets, ability to withstand long periods of illiquidity and appetite for greenfield and emerging markets projects. Less trodden opportunities remain. Investment flows into agricultural assets, for example, have under-paced that of many other real asset alternatives. These investments can take on countless forms, from direct or derivative ownership of a range of commodities, land or operations linked to the food chain, and should not be overlooked. The space is not yet crowded, leaving opportunities for those with pioneering spirit.

At the surface, the base case for investing in food and agriculture is an obvious one, underpinned by the simple fact that humans need about 2,000 calories per day to survive. Research, in ad nauseam, has repeated the argument that world population is rapidly climbing to 10 billion, and therefore agricultural demand will rise exponentially. Despite the miracle (or debacle) of advancing GMOs, the supply side simply won’t be able to keep up with demand. The future, however, often doesn’t pan out immediately as foretold. Agriculture prices, instead, have faced deflationary pressure from technological innovation that has enabled production to rise above trend. But, according to Greg Presseau, Senior Portfolio Analyst at Perennial Management, “grains and oilseeds are increasingly attractive in this environment.” The technological innovation, he says, “has also led to increased demand in the form of biofuels with China likely to commit to a 10% ethanol blend that would soak up total grain stocks in two years unless production is expanded.” Current prices do not warrant expanding production – prices should rise. While these enticing trends illuminate a range of investment opportunities from field to fork (upstream, midstream and downstream), navigating issues like weather, access to water or soil and animal health can be a challenging one for investors to tread. Difficulty in understanding these particular risks may in part be mitigated by an active manager seasoned with years of hands-on experience in the industry. Portfolio implementation, however, requires judicious review.

There are many ways to employ capital to agricultural assets – physical commodities, options and futures contracts, public and private equity, and farmland – ranging from extremely liquid to deeply illiquid, and managed actively or passively. Each has their own unique risk profile, but the results of all have demonstrated low correlation to traditional assets, with the potential of producing considerable returns, over the long-term. Farmland, for example, famously dubbed “gold with a coupon” in the Economist, lures with both yield and capital appreciation. Owners of US farmland have garnered stable long-term returns of 12% per annum over the past decades, though some pundits discount the result as a land price bubble. And while the Common Agricultural Policy has greatly distorted the market in the European Union, it has to a large extent made agricultural production more stable and predictable. In any case, there are only a limited number of agriculture-focused funds, managing scant AUM relative to the numerous funds deploying vast capital to infrastructure and real-estate, leaving much head space for investors and asset managers alike.

The performance of real assets – commodities, real-estate and infrastructure – of course fluctuate widely in different market conditions. So, too, do the results of the myriad of volatility trading strategies. Each, however, tends to demonstrate a low correlation to stocks and bonds over most market cycles. Accordingly, a typical institutional portfolio, heavily weighted towards stocks and bonds, can benefit from the portfolio volatility dampening effect of increased exposure to these assets. Sufficient inclusion, over the long-term, can provide positive results while defending portfolios from market woes. Real assets, in particular, can prove invaluable in the confront of inflationary pressure. Most investors, however, will not contemplate allocating more than single-digit percentages of their portfolio into real assets even this amount can provide some level of protection should inflation join the party and force central bankers to take the punch bowl away.