Positioning Portfolios for Inflation

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Michael Sager

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Michael Sager, vice-president, multi-asset and currency management at CIBC Asset Management.

Inflation hasn’t been a risk that investors — particularly in North America — have had to think about, particularly for the last two decades. We do think it’s becoming a little bit more relevant now and for the next few years. To be sure, we don’t think we’re going back to a world of inflation that we were used to in the late ’60s or the ’70s or part of the ’80s. That’s not on the agenda. But a little bit more inflation relative to what we’ve seen — particularly in the last 10 years — is likely.

We can see it from a number of factors — base effects would be the first ones. This time last year, crude oil prices, airline ticket prices, for example, all went into negative territory. Crude oil now is trading above $60 a barrel. So, a very significant year-on-year positive, that will impact consumer prices. So, at the most trivial level, base effects are going to drive inflation higher.

More importantly, we can see a broader set of input and output price pressures that are relevant and are likely to drive inflation, particularly in the U.S., a little bit higher. The weakness of the dollar over the last few quarters and, respectively, will be another cost-push pressure that will drive inflation a bit higher.

And then finally, policy-makers have an incentive now to generate a little bit more inflation. The Federal Reserve’s policy target has been changed from a target of 2% inflation to a target of an average of 2% inflation. And what that means substantively is that it’s going to tolerate overshoots above 2% inflation to compensate historic undershoots. That’s a big difference.

Why are they willing to tolerate it? Well, part of the reason is because of the amount of debt in the economy. There’s been a veritable huge debt increase in U.S., in other developed currencies and countries over the last 12 months, associated with the efforts to recover from the lockdowns related to Covid-19. That debt has to be paid. One way to pay it off with a little bit more inflation. So, policy-makers are motivated to generate more inflation, not only the U.S. but particularly the U.S.

So, going forward, we do think we could see a little bit more inflation. Probably in the second quarter of 2021, headline U.S. inflation will print close to 4% year on year, compared to an annual average for the last 10 years of about 1.7 — so, a material increase. After Q2 that 4% will probably drift down a little bit, closer to 3% year on year for the next couple of years. But that’s a material change, and it has important implications for how we think about portfolio construction and portfolio positioning.

So, more inflation does have implications for portfolio positioning and portfolio performance. And it’s important that investors really think about this. Nominal bonds tend to underperform when inflation rises; equities don’t do quite as well, although we think equities can still continue to go up as an asset class over the next few years. But it’s important to supplement a traditional equity and bond portfolio with other asset classes and strategies that are much more inflation aware. A strategic allocation to gold, for example, is something that can work when inflation and inflation uncertainty are rising. A tactical allocation to cyclical commodities like oil typically works well when inflation is going up a little bit. Real assets, things like index-linked bonds or real estate or infrastructure, again, can all do well or — if you put it another way — hedge exposure and protect against the risk of inflation.

So, whatever your focus whether it’s to try and benefit in terms of returns from an increase in inflation, or whether it’s to protect your portfolio against the impact of a little bit more inflation, tactically exposing the portfolio to cyclical commodities, allocating to real assets like real estate infrastructure, makes a lot of sense to me.