Preparing a Portfolio for Shocks to Economic Factors

At Franklin Templeton, our exploration of the impact of shocks is intended to help ourselves and other investors think more productively about the “What if...?” asset allocation decisions. That is, the most beneficial discussions come from exploring the implications of what might happen—not guessing the future—and then being prepared for those risks. Conversations with investors inside and outside spark our thinking.

Economic Growth—Defensible Space

Wylie Tollette: Economic growth is one of those factors that is just so intrinsic and so baked into every element of an investor’s perspective that you really need to think about it deeply. The term “defensible space” strikes me as Important for investors to consider building into their portfolios, relative to their exposure to economic growth, because fires can emerge in economic markets. Growth tends to move a little bit more slowly, but recessions can emerge fairly quickly—they climb like a feather on the wind, but fall like a stone.

Gene Podkaminer: We’re all poor at predicting inflection points. We’re not at one, in our view, but we should always be thinking about inflection points and positioning portfolios to take advantage of them. You’ve got to be prepared for what may happen. If that means using diversification as a form of insurance, I think that’s a pretty good trade.

Tollette: I’d be looking for hedges and diversification that still have a positive return. We’re looking for positive carry investments that still diversify equity growth. Things like explicit factor strategies are the first step down that path or assets that have exposure to other fundamental factors, such as interest rates and inflation. These factors also tend to diversify economic growth, so there is no better time to build that into our overall longer-term perspective. What is key is not looking backward. Let’s look forward. What are we expecting?

Inflation—Good or Bad Cholesterol

Podkaminer: Oftentimes, inflation is hidden. You can see exposure to it, in real estate, in commodities, and in TIPS. You can quibble with the supply and demand issues of TIPS pricing, or if CPI is a great inflation measure, or whether it should be the GDP deflator or something else. But within TIPS, you do have actual exposure to inflation. Arguably, over longer periods of time, you can feel it in the equity markets also. To me, what’s interesting about inflation is that global growth is a well-known factor. Interest rates are well-known, well-appreciated. But inflation hasn’t gotten a lot of air time.

Tollette: A high inflation environment is unfamiliar to most people in developed countries. We haven’t seen high inflation in the US or most developed markets since the 1970s. Many portfolios have drifted away from explicit inflation hedging, which tends to be costly. People can tolerate the price, stand the opportunity cost for a few years, but then they get tired of paying to own commodities or specific inflation hedges or swaps, so they give up on that. That may be a rational choice—to look for intrinsic inflation hedges that are built into other asset classes, such as in rental real estate, that don’t have the same opportunity costs.

Podkaminer: When I’m thinking about inflation, it’s kind of like cholesterol: there’s good inflation and there’s bad inflation. I want to see good inflation that’s caused by productivity increasing in economies, by things overheating because we have healthy consumption. That, to me, is relatively good inflation. We understand how that cycle works and how to deal with it. Bad inflation is what you see happening in a lot of emerging markets where you’ve got very little control over monetary policy. As you relinquish that control, you start to see interesting things happening to your home inflation rate and also to your currency. That’s the bad cholesterol.

Tollette: It can creep up on you year after year. If you’ve counted on 3% inflation on your asset side and that’s what you targeted to achieve, but your obligations are increasing by 4%, that might not look like a lot in any given year. Over 10 years, however, that will create a real funding problem.

Podkaminer: Inflation is a ninja—you heard it here first. A shock to global growth will flatten you, but you’ll see it coming. Interest rates are a little bit subtler, but again, you can see that coming. Inflation will kill you in stealth.

Interest Rates—Back to the Future

Tollette: If you look back to the 1950s and 1960s, the typical institutional investor had a lot more fixed income in their portfolio. They were yield-focused investors, and fixed income provided a relatively secure, five-, six-, even seven-percent annual yield. It was solid.

Podkaminer: And it was tied closer to their liabilities as well. There was a real ability to substitute fixed income for equity because fixed income gave you pretty healthy returns without taking on a ton of risk. Equities gave you good returns too, but they were substantially riskier.

Tollette: People may think of fixed income as a low-volatility asset class. But look at Treasury Bonds from 1978 to 1985. They can be just as volatile, if not more volatile, than equities.

Podkaminer: We’ve seen this secular decline in interest rates over the past 40 years. At some point, we’re going to hit an inflection point where we’re going to be learning a lot about what it means to live in a rising rate environment. We don’t have a lot of good history to anchor that on. Episodically over the last two centuries, there have been periods when interest rates have risen, but it will be interesting to see how market participants react now that we have more developed capital markets, and also how central banks react to rising interest rates and the kind of feedback that produces for investors.

Tollette: With that changing, it will be very interesting to watch how investors react when yields start to climb. If yields climb slowly and predictably, I think investors can react. That could be healthy overall for the financial markets in the long term and provide a little bit more balance in return expectations across these macro risk factors. But the process of adjustment may be disruptive and unpredictable.

Today, the bulk of most institutional investors’ portfolios, and many individual portfolios, are in equities. That’s been a huge sea change in the past decade.

Podkaminer: What we’ve been seeing more recently is that when there are terrible days in equities, usually you see that impact on the other side of the street with Treasuries. Imagine a world, where: if instead of that kind of reaction an investor could actually say, “Okay, I’ve got some fixed income. It’s producing a reasonable yield. Maybe I don’t need this equity instrument over here.” We’ll see.

Tollette: The first thing I would plan to do is to really analyze my portfolio, and of course, understand my total exposure to economic growth-related risks. Not just across equities; but, as Gene said, across all my asset classes. The next thing is to understand your exposure to unexpected changes in rates. Again, not just across fixed income, where that is fairly mechanical and mathematical, but across every asset class—including real estate, private equity and real assets.

Podkaminer: That is the hard part. When we talk about “across every asset class”, it’s tough to understand what the duration or the interest rate sensitivity of equities is.

Tollette: You can’t mathematically calculate it.

Podkaminer: No, you can’t. There have been some interesting academic studies about it. We know intuitively that inflation is passed through equities because as prices go up, and as input prices go up, eventually the consumers will feel the uptick, too. There’s a process by which that gets digested through the equity markets: but, it’s not as mechanically linked as it is in fixed income, and it’s certainly not as mathematically elegant. The challenge with looking at growth and inflation and interest rates through all of your asset classes is that you need to have both the mindset and the tools to do that.