Let’s Get Real About Inflation
by Jon Ruff (pictured) and Greg Wilensky of AllianceBernstein (NYSE:AB)
For the US and other developed economies right now, it’s “all quiet on the inflation front.” Perhaps too quiet. That’s why we believe it’s time to get real about inflation and the investing opportunities that may well develop in the next several years.
In 2013, falling global inflation expectations and weaker emerging-market growth forecasts caused a hefty decline in most real-asset investments—natural resource stocks, commodity futures and real estate stocks. As real assets underperformed stocks, inflation-indexed bonds such as Treasury Inflation-Protected Securities (TIPS) underperformed their nominal Treasury counterparts.
Both real assets and TIPS are relatively inexpensive today. That, however, may not be enough incentive to buy them now, since collective market expectations see little chance for rising inflation in the near term. Some may argue that deflation or disinflation has a greater likelihood. But with all the monetary easing of the past few years, the scrappy resilience of the global economic recovery and developed-world central banks looking for some economic heat, isn’t there even the chance of inflation?
We think it’s wise to be prepared, which is why we see real assets and TIPS as appealing opportunities now—and always. After all, asset classes have a way of shifting from winner to loser (and back again) more quickly than expected, and these asset classes could move extremely quickly if inflation expectations increase.
If you compare historical annual returns for a balanced basket of commodity and real estate investments with the S&P 500 over the past four decades, you’ll see some extraordinary shifts in over- and underperformance. Let’s look at 1975–1976 and 1997–1998—two time periods when real assets got pummeled as they did last year (display below). The story in 1975 was that inflation collapsed nearly five percentage points (from 12.0% to 7.4%), causing these inflation-sensitive assets to underperform. In 1998, the spotlight was on the extraordinary tech boom, and old-economy businesses like real estate and commodities were just about the most out-of-favor sectors around.
After each of those periods, real assets posted strong rebounds for the following three- and five-year periods—in conjunction with economic recoveries and the end of declining inflation rates.
What about TIPS versus Treasuries? TIPS underperformed last year as US and global inflation expectations fell. Today the breakeven inflation rate on 10-year TIPS is about 2.2%. If inflation exceeds that breakeven rate over the next 10 years, then investors would be better off owning TIPS. For some historical perspective, the inflation rate has averaged roughly 2.4% over the last 10 years and 2.6% over the last 20 years. So, the current 2.2% breakeven looks attractive.
Will we get rising inflation this year? Next year? Maybe, maybe not. But when inflation does eventually pick up, it could potentially cause a good deal of harm to traditional portfolios of stocks and bonds, both of which underperform during times of rising inflation. Therefore, we think investors would be wise to include an allocation to real assets and TIPS that can protect their portfolios from the negative impacts of inflation.
While TIPS provide appropriate inflation protection for investors’ fixed-income allocation, they don’t have enough inflation sensitivity to protect investors’ stock allocation. That’s a job for real assets. Therefore, we feel it makes sense for investors to add a combination of TIPS and real assets to their retirement portfolios. An additional benefit of blending these asset classes together is that the combination will be less volatile than using real assets alone.
In any case, we feel that inflation-sensitive assets should probably not dominate a portfolio. They should play a modest, complementary role that helps the longtime purchasing power of a portfolio fend off inflation’s ill effects.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Jon Ruff is Lead Portfolio Manager and Director of Research for Real Asset Strategies and Greg Wilensky is a Director of US Multi-Sector Fixed Income at AllianceBernstein.