Inflation poses a duration problem for investors
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The writer is chief executive of AllianceBernstein
Expectations of future inflation have steadily increased over the past year and are now above the pre-pandemic level.
This has led to a lively discussion on the impact that higher inflation, bond yields and the recent sell-off in some high-profile, fast-growing companies may have on financial markets.
It is not surprising that inflation is higher in 2021 than it has been over the past two to three years, as it almost mechanically follows the pent-up desire of many households to spend because of the Covid-19 global pandemic, leading to an increased demand meeting tight supply.
The key question for investors to ask is whether this inflation can persist beyond the “reopening trade”. We believe that it can.
In our view, the primary force for higher inflation is the change in the policy environment, which has the potential for more active use of fiscal tools. It will be needed, as policymakers will have to overcome deflationary forces that are likely to emerge once the reopening trade is over, including slack in labour markets and the ongoing tendency of technology to drive down prices.
However, policymakers are likely to prefer moderately higher inflation to reduce the value of higher debt levels. This leads us to believe that investors will have a problem with duration, a measure of how long it takes for an investor to recoup an asset’s price by its cash flows.
Another way of thinking about duration is that it represents the sensitivity of the price of an asset to changes in yields. Thought about in this way, it can apply to all asset classes, not just bonds.
As yields have moved down in recent years, the duration of high-grade bonds has increased — ie they have become more sensitive to changes in yields as even small moves at lower levels can have an outsize impact on how long it takes an investor to get their money back. Thus, bond investors are more exposed now if interest rates rise.
So far, simple cross-asset portfolios, such as those that use a 60:40 allocation for bonds and equities have been shielded from this. This is because these asset classes have had negative correlation in recent decades — when equities suffered, bonds have rallied and vice versa.
If inflation rises strongly, this is less likely to be the case. At moderate levels of inflation, bonds would sell off but equities would be more resilient as earnings would rise. But at higher levels of inflation, both equities and bonds would suffer from the prospect of interest rate rises.
Ultimately, this upends the narrative of the past decade whereby investors have increasingly made passive long-only investments in equities and fixed income.
That approach is inherently riskier when seen in the light of this policy environment. If fixed income no longer hedges equity risk, then a new model of cross-asset investment may be needed. This raises questions for many popular approaches that individuals use to save for retirement.
Investors should adjust to hold more “real” assets and to move explicitly to reduce their duration risk. Real assets include physical assets such as infrastructure and real estate, but one can argue that public equities can count as a real asset as dividends can rise with inflation.
Another area that might see demand is digital tokens of physical assets maintained in a “blockchain” across a network. This is potentially a technology in the right place at the right time in this regard. But the real driver of adoption will be real asset demand, not the technology per se.
Any prolonged period of inflation would also probably be supportive of the strategy of buying undervalued companies in the market, or value investing. Such assets generally have higher yields and so a larger part of the present value is from cash flows in the near term. Hence they are less sensitive to shifts in long-run interest rates
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There are still plenty of headwinds to the value factor, not least the way that technology has destroyed “moats” that protect certain industries from competition. These prompt questions of exactly how “value” is measured. But if higher inflation persists, value strategies can be part of investors’ response to a duration problem.
If we are in a new policy environment that creates a more persistent narrative around inflation, then investors need to address the challenge of duration more broadly in their portfolios. That is likely to overturn many long-held assumptions about appropriate asset allocation.
Inigo Fraser Jenkins, co-head of portfolio strategy at Bernstein Research, contributed research and analysis to this article
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