Tilting Portfolios to Take Advantage of Inflation Cycles

(May 7, 2013) — Investing in inflationary environments continues to haunt CIOs dreams, but new research from Fidelity could provide an insight into which asset classes perform better at each stage of the inflation cycle.

Rather than looking the phenomenon from a binary perspective of either being in an inflationary environment or a deflationary one, Fidelity analysed the behaviour of asset classes throughout the entire cycle of inflation rising and falling, studying each cycle since 1973.

Fidelity discovered if investors are able to identify the correct economic conditions at the right time, they can tilt their investment portfolios towards assets that are likely to fare best.

For example, during the “Overheat” phase, when productivity slows and inflation climbs driven by limited slack in the economy and rising demand, commodities typically perform well. And during periods of Stagflation, when inflation continues rising and growth falls below trend as rate hikes take effect, commodities continue to outperform, but with a higher degree of risk as sentiment weakens.

When growth starts to decline but inflation remains high, precious metals and energy commodities tend to outperform, but they do come with associated costs, such as exposure to geopolitical and supply risks, that drive price volatility upwards. Liquidity constraints and taxation can also be issues that require close consideration for certain assets and jurisdictions.

Real estate, typically used by many funds as an inflation hedge, usually see an increase in value before a period of inflation.

The long-term performance of the commercial real estate market in most developed markets is driven by income return. Therefore, Fidelity claims real estate performs best in periods of moderate-to-low inflation (i.e. Retail Price Inflation that is less than 6% per annum).

Equities meanwhile, tend to be resilient when the level of inflation is modest because companies can pass on cost increases without impacting profit margins materially. But beyond a certain level of inflation — again around 6% — equity returns deteriorate with expectations that margins and earnings will be challenged in a difficult interest rate and growth environment.

Fixed income is more difficult – bonds typically perform badly in inflationary times, but inflation-linked bonds can deliver precise hedges, but can suffer from price volatility and are sensitive to interest rate changes and market liquidity.

Fidelity believes near-term global inflation is likely to remain contained, but argues it is important to protect real returns across all scenarios, not just when inflation is expected to rise.

“The fact that there is no one asset that fits the bill in all environments calls for a diversified and dynamic approach to inflation protection which targets real returns across an ever changing backdrop,” the report said.

But it also warned: “In tilting portfolios to accommodate forward expectations of inflation, it is important not to churn allocations in a binary and costly fashion.

“In this context, an effective multi-asset strategy is one that targets stable real returns through the business cycle and is constructed with explicit awareness of desired risk levels, the time horizon and objective of the investment.”