SHOCKS TO MACROECONOMIC FACTORS
CONTRIBUTORS
Gene Podkaminer, CFA
Head of Multi-Asset Research Strategies, Franklin Templeton Multi-Asset Class Solutions
Laurence B. Seigel
Director of Research, CFA Institute Research Foundation
Preview
Inflation, fast or slow, seems to be a fixture in our fiatmoney system. Today, inflation is running at a mild rate near 2% per year, a rate low enough to escape some investors’ notice—but 2% inflation is still inflation. At that rate, prices double every 35 years and rise more than sevenfold in a century. Moreover, inflation isn’t guaranteed to remain that low. In the lifetime of the authors, it has ranged as high as 13%, a rate steep enough to severely damage any portfolio that is not properly protected against inflation.1 It could happen again.
Inflation also directly affects liabilities. Whether the liability is a legal obligation, such as with a defined-benefit (DB) pension plan, or a conceptual obligation such as the need to fund one’s retirement or the spending plans of an endowed institution, inflation flows through to liabilities in a way that must be accounted for when setting investment policy.
The “stagflation” of our youth, if you’re of a certain age, turned to “doeflation” (Peter Bernstein’s memorable wisecrack) so long ago—sometime in the 1980s—that it can be hard to focus on the necessity of protecting portfolios against inflation, both anticipated and unanticipated (a distinction we’ll clarify below). In this paper, we reaffirm the importance of understanding and protecting against inflation shocks, assess what is likely to influence inflation rates in the future, and identify asset classes and strategies for defending the real value of assets against erosion by inflation.
In an earlier work, two of us said, “Inflation is a ninja. A shock to global growth will flatten you, but you will see it coming…[But] inflation will kill you in stealth. 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 may not look like a lot over any given year. Over 10 years, however, that will create a real funding problem.”2
Inflation and Real Interest Rates
This paper is a companion to our “Real Interest Rate Shocks and Portfolio Strategy” (September 2019). Inflation and real interest rates, as concepts, are joined at the hip. One has little meaning without knowledge of the other. They sum to the nominal interest rate, which (for US Treasury bonds) is the most important observable variable in finance. (The other “most important” variable, the equity risk premium is not observable.)
But it is unwieldy to deal with these very different risks in a single paper. We chose to divide protection against real interest rate shocks and protection against inflation shocks into two papers because they are distinct risks with dissimilar origins and different future prospects.
ENDNOTES
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In the post-World War II period, that is the highest rate for any full year (1979). The highest monthly rate was 1.81%, which annualizes to 24% (August 1973).
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Tollette, Wylie, and Gene Podkaminer (2019).
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