Building Inflation Buffers for Portfolios

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Michael Sager

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Michael Sager. I’m vice president, multi-asset and currency, at CIBC Asset Management.

Let’s turn to thoughts about inflation and its impact on investment portfolios and how investors should think about mitigating the impact of inflation risk on a portfolio performance. Our view is that we’ve probably reached the peak in year-on-year inflation in the U.S. and Canada and we’re likely to see a gradual weakening in inflation pressures over the next 12 months or so. But that doesn’t mean that inflation is not relevant as a risk to think about. We think it still will be a relevant investment risk for the next 12 months for a couple of reasons. Inflation at current rates in the U.S. around 5% year on year is definitely relevant to the performance of asset classes like equities, bonds and alternatives. And also inflation volatility is higher than we’ve got used to. And again, that inflation volatility will be relevant to asset performance.

One way to position either to hedge against inflation risk or to benefit from inflation is to embrace an allocation to various alternative asset classes and strategies. A couple of examples. The first example would be commodities. A number of commodities typically do well when inflation and inflation volatility are relatively high. I’m thinking about oil, I’m thinking about gold, for instance. For both of those, the inflation beta is relatively high. So when inflation increases, the return increases disproportionately. They have a beta to inflation, greater one, particularly oil. They also tend to have a relatively high inflation success rate, by which I mean that more often than not, they outperform other asset classes when inflation and inflation volatility are relatively high. So a high inflation beta and a high inflation success rate is what you’re looking for in asset classes. So commodities certainly can offer that, at least historically have done so. Real assets also provide a similar opportunity, particularly infrastructure, where you have often explicit links to inflation in infrastructure contracts, the underlying infrastructure contracts that investments in infrastructure as an asset class seek to tap into.

So again, infrastructure as an investment within real assets tends to do relatively well when inflation and inflation volatility are relatively high. The final alternative that I would think about when trying to either benefit from inflation and inflation volatility or hedge against it would be absolute return investment strategies. These strategies are designed to perform well regardless of market environment, whether inflation is up or down, growth is up or down, they’re very resilient strategies. They perform in or seek to perform in these various market environments by having a lot of investment breadth. A lot of them embrace a wide variety of asset classes, a wide variety of strategies, including investments in commodities. And also the ability to go both long and short in alternatives and traditional assets. So absolute return strategies, to give an example, would include global macro investing, where you’re trying to capture the impact of a global macro event. Risk and inflation and inflation volatility would certainly come under that umbrella.

So let’s think about other factors that might impact investments and the outlook for asset returns through 2022. Clearly Fed policy and the policy of other central banks and U.S. fiscal policy are going to be relevant. We think that Fed policy has fairly well been signaled so shouldn’t be too impactful to asset returns. But of course, there’s always risks.

One of the key drivers beyond policy that we would think about is the tug of war as it were between cyclical growth and valuation. This is particularly relevant for equities and the outlook for equity investing. Valuations are becoming increasingly stretched. So a number of equity markets, particularly, for example, U.S. large cap, are at relatively high valuations. So that will present an increasing headwind to equities as we progress through 2022. We think that the outlook for equities and pro risk assets broadly through 2022 will remain relatively positive, not quite as good as the recent years, expected returns are lower than historical recent returns. But nonetheless, it will be a broadly supportive outlook, we think, for equities and pro risk assets.