For the past 15 years or so, nearly every discussion on investing contained the phrase, “in a low-interest-rate environment.” Many business writers probably have that phrase programed into a shortcut button on their keyboard. As with everything COVID, things seemed to have changed overnight. Now, every commentator and analyst is talking about inflation. Are we in an inflationary era? If so, how high will it go? Is it transitory or should we reprogram those “low-interest-rate environment” keys to “rising inflation” keys? And what should investors be doing to take advantage of — or at least protect themselves from — rising prices that reduce returns?
THE INFLATION DEBATE
There can be no debate on whether prices have gone up in 2021. In October, the headline inflation rate, which includes food and energy, hit 6.2 percent over the previous 12 months. This spike exceeded expectations and was the highest it’s been in 30 years. The index for all items except food and energy, or the core inflation rate, was up 4.6 percent over the year, according to the U.S. Bureau of Labor Statistics. The Federal Reserve aims for a 2 percent growth, ascertaining that this is enough to keep the economy humming along without overheating. So, prices are rising at three times the optimal rate — and in this case, more is not better.
Debate comes into play on whether this surge is simply a COVID-fueled transitory phenomenon based on pent-up demand, supply-chain disruptions and a labor shortage that makes it hard to meet the demand, or the beginning of a longer-term change in the economy. How inflation plays out in the next year could have a significant impact on investments.
Treasury secretary Janet Yellen has been quoted as calling the rise transitory, but the definition of transitory is a bit squishy. Does it mean that we will be seeing prices on the rise for just a few months, or that the upward trend won’t last forever? Yellen told CNBC that she believes monthly rates will come down in the second half of 2022 and that we will see a return to levels close to 2 percent, though she admitted the current high inflation rate has been more stubborn and longer-lasting than expected.
The consensus outlook seems to be in agreement with Yellen’s timing forecast, with opinions coalescing around prices stabilizing in the second half of 2022, but most think inflation will continue at a higher level than the Fed expects. A Wall Street Journal survey of economists predicted consumer-price inflation will drop to 3.4 percent by June 2022, then 2.6 percent by the end of 2022, according to respondents’ average estimates. That is still above the average 1.8 percent that prevailed in the decade before the pandemic, but certainly not out of control inflation.
Joining the chorus of economists who predict higher-than-pre-COVID inflation, at least through 2022, is Kathy Bostjancic, chief U.S. financial economist at Oxford Economics. “Our sense is that the inflation and price increases will get worse in the near term before they get better,” Bostjancic noted on CBS News. Her forecast is that headline inflation will stand at about 5.3 percent in the first three months of 2022, but may start to ease in the second quarter.
Other economists aren’t so sure the spike in inflation is all that temporary.
“The consensus view and the view that we’re hearing from central bankers is that this is a temporary/transitory phenomena, and that inflation will likely settle back at pre-COVID rates once all of these temporary factors have dissipated,” says Ed Campbell, managing director and portfolio manager for QMA, working within the Global Multi-
Asset Solutions Team at PGIM. “And that’s certainly possible, but we believe that the inflation risks are greater than the consensus view. … We agree that inflation is likely to come down from current levels, but it’s also possible that price increases stay sticky and take longer to fall back to levels that central banks would be comfortable with and that the consensus is currently expecting.”
Campbell added this is not a 1970s scenario, but PGIM believes it’s seeing the end of the four-decade trend in falling inflation, and that inflation is likely to head higher over the next decade. “Inflation should average around 2.3 percent over the next decade, but could go as high as 3 percent to 4 percent,” he predicts.
Factors portending long-term inflationary pressure include changing demographics, political pressure to expand government spending, and the amount of spending necessary to mitigate the climate crisis. There is also the fact that people expect inflation to rise, which can be a self-fulfilling prophecy. If you think something is going to be more expensive next year, you are likely to buy it this year, which adds to demand pressure and rising prices.
What everyone seems to agree on is this bump will not be like the 1980s, when headline inflation was roaring along at more than 14 percent. Yet, even a 3 percent inflation rate can make a difference when your portfolio was structured for an inflation rate of less than 2 percent.
ASSETS FOR UNSETTLED TIMES
So, what are some of the best places for an investor to look in 2022? Well, real assets have long been touted as safe harbors during times of rising inflation. It’s been a while since we’ve tested that received wisdom, but many professional portfolio managers are ready to act on it.
BNP Paribas Wealth Management expects core inflation to eventually settle into the 2.7 percent range. As such, it is recommending a focus on assets with a) an essential product or service, b) a positive real yield and c) consistent cash flows. The group favors real assets, such as listed real estate and infrastructure, as well as commodities to some extent, that are cheap relative to bonds and cash.
“Yields offered by traditional fixed income remain at historical lows,” says Edmund Shing, global CIO at BNP Paribas Wealth Management. “In contrast, infrastructure and property funds can generally generate annual yields of approximately 3 percent to 4 percent, which is very attractive compared to the very low yields in fixed-income universe.”
Research from Neuberger Berman indicates REITs can be an especially attractive investment when inflation rates are rising. According to the firm’s data, the FTSE NAREIT All Equity REITs Index of U.S. real estate securities has outpaced inflation during the past 20 years in every year except 2009, when all real estate was impacted by the global financial crisis.
Although management strategies account for much of this growth, additional data indicates that inflation appears to be a significant tailwind. In the 12 years since 1991 when inflation was less than 2 percent, the average return of the REIT Index was 7.4 percent. If we drop the outlier year of 2008, that average rises to 11.5 percent. But the average return for the 18 years when inflation was above 2 percent was 16.5 percent. Periods of higher inflation appear to have benefitted REITs.
Slicing the data a little finer, Neuberger Berman finds that during this period, REITs outperformed in seven of the 12 years with low inflation (less than 2 percent), in seven of the 12 years with moderate inflation (2 percent to 3 percent), but in five of the seven years with high inflation (greater than 3 percent). And, the two years in which they underperformed during high inflation were 1990 and 2007, which were both years when the real estate sector in general was hammered. So, if you expect inflation to settle in above 3 percent, REITs could very well be a good place to be.
Commodities are also likely to benefit in times of higher inflation. Given their volatility, including commodities as a hedging strategy might seem counterintuitive, but not all commodity sectors are the same. In fact, commodities are a natural hedge to inflation because the CPI includes a commodity basket. “Commodities’ response to inflation could depend on the commodity and time period, but when you look at commodities as a whole, they still provide attractive inflation-hedging properties, especially against unexpected inflation,” explains Yesim Tokat-Acikel, managing director and portfolio manager for QMA, working within the Global Multi-Asset Solutions Team.
According to PGIM Research, when inflation is below 2 percent, as it has been for quite some time, commodities are not a very attractive asset.
“However, when you look at inflation in line with our expectations in the 2 percent to 3 percent range, plus potential inflation in the 3 percent to 4 percent range, we think commodities start to look very attractive as a necessary input with elastic supply and demand, especially over shorter-term periods,” says Tokat-Acikel.
ON THE OTHER HAND
Although the case for real assets during rising inflation seems obvious, a few researchers are saying, “Wait. It’s not that simple.”
Jason Benderly, president of Benderly Economic Insights and Randall Zisler, chairman of Zisler Capital Associates and Outsourced Research have looked at correlation coefficients going back 20 years and have come to the conclusion that real estate is an inconsistent inflation hedge, at least in the short term. Longer-term, it is a good inflation-
adjusted store of value.
“Capital appreciation has some inflation hedging power, but it is also inconsistent,” explains Benderly. “The range of the correlation coefficient, by definition, is between negative one and positive one. A good inflation hedge would have a consistent correlation coefficient significantly greater than zero. However, we find that the average of the 20-year moving correlation for real estate is about 0.2 for the total return, but negative 0.3 for the income return, which comprises 80 percent of the total return. The length of the leases made no difference in the results. The rolling income and appreciation correlations for apartments are similar to those of other property types.”
Despite all the chatter and speculation around where inflation will land in 2022, at least one researcher thinks investors are focusing on the wrong thing.
“While inflation can certainly have an impact on a portfolio, it is more the uncertainty surrounding the changing economic environment than inflation per se that causes volatility in the market,” explains Zisler. “As such, we don’t believe investors should be overly focused on inflation as a risk-factor. There is no indication that we are on the verge of runaway inflation, nor that higher inflation rates will continue through multiple business cycles. The Fed and markets have shown they can contain inflation if they want to, so I believe that any significant pickup in inflation will be very limited.” He aids that “the recent uptick is inflation reflects supply chain bottlenecks and rising demand for durables. Jason and I still believe that the uptick is transitory.”
As such, maybe we don’t need to readjust portfolios just because inflation might settle in north of 3 percent in 2022. A diversified portfolio, in and of itself, might be all that is needed to protect investors from the ups and downs in the economy.
BOTTOM LINE
Whether prices continue to increase at 2 percent or 4 percent, and whether that rate continues for three months or three years, it seems a safe bet to say the sub-2 percent inflation days are behind us. Real assets, particularly real estate, infrastructure and carefully chosen commodities can act as an insurance policy to protect a portfolio, no matter where prices go. If the risks materialize and inflation is higher than 4 percent, which is not expected but could happen, the income and appreciation components of real assets can rise, as well — though investors should expect a short-term lag. If inflation remains moderate, investors still have income and returns comparable to the other asset classes in their portfolio, so nothing is lost. In other words, real assets are a good bet in any economic climate. And while there is some indication they are a poor hedging strategy in the short-term, they are often considered a better bet than the alternatives. 2022 might just be the year we find out if that thesis is accurate.
Sheila Hopkins is a freelance writer based in Auburn, Ala.