Investors have been selling inflation protection in the mistaken belief that it’s no longer needed. They’ve helped create a unique opportunity.
As inflation recedes from recent cyclical highs, many investors are selling their holdings of inflation-protected securities. The result? Explicit inflation protection has become unusually cheap. Investors needing to boost their strategic allocations to inflation strategies may wish to take advantage of this opportunity—securing inexpensive “flood” insurance ahead of higher structural inflation over the coming decade.
Entering a Regime of Higher—and Spikier—Inflation
For the past 40 years, global deflationary forces have prevailed, facilitating a regime of low equilibrium inflation. But mounting pressures from macro megaforces point toward higher structural inflation and increased vulnerability to inflation shocks in the years ahead. At the core of our expectations are three powerful forces: deglobalization, aging demographics and climate change.
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Deglobalization leads to higher inflation by constraining the global pool of labor and increasing labor’s bargaining power, among other factors.
- Meanwhile, the global labor pool is shrinking, thanks to aging demographics. Without a sustained increase in productivity to offset it, a shrinking workforce empowers labor—yet another inflationary factor.
- The inflationary effects of deglobalization and demographics could be compounded by climate change. For instance, the energy transition—while probably deflationary in the long term—could drive costs higher in the next decade.
As a result, we think it’s more likely that 2% becomes a lower bound for inflation, rather than a central-bank target. Indeed, it’s highly likely we’ve already entered this new regime, though evidence of it has been masked by recent disinflation from cyclical highs. That said, frequent surges in inflation may themselves be characteristic of the new regime.
As we’ve all recently been reminded, surges in inflation hurt. In the last three years alone, US consumers cumulatively lost 16% in purchasing power. It’s no wonder consumer sentiment bottomed in 2022. Yet even marginally higher inflation represents a key risk. For example, if inflation persists at just 2.8%, an unprotected investor will have lost 35% of purchasing power 15 years from today and be farther than expected from meeting investment objectives.
The Case for a Strategic Allocation to Protection
Inflation is hard to predict. Many investors—and even central bankers—have underestimated the frequency and magnitude of inflation. When we compared market inflation expectations1 to realized inflation over the last 18 years, realized inflation came in above expectations more than 80% of the time. On average, the market underestimated inflation by 1.41%, while overestimating by just 0.66%, putting the odds in favor of a strategic allocation to inflation protection.
During inflationary periods, there are very few places to hide. Even core fixed-income investors need to take a hard look at whether their allocation stands up to rising interest rates coincidental with rising inflation. In our analysis, over the past 14 years, investors could have generated higher returns with lower volatility by substituting some of their core bond allocation with an inflation strategy that included Treasury Inflation-Protected Securities (TIPS).
That’s why, in our view, the wisest defense against unexpected inflation is to maintain a strategic allocation to an active inflation strategy that includes explicit inflation protection in the form of TIPS.
Putting a Price on Protection
Today, inflation protection is unusually well priced. In the 27 years since TIPS first came to market, TIPS yielded an average 90 basis points below GDP growth. But now, following a sharp increase in real yields, TIPS investors can lock in a real yield of 2%. That’s above the US Bureau of Labor Statistics’ projected real GDP growth rate for the US economy over the next decade.
In other words, TIPS are abnormally cheap today relative to long-term averages; they’re also cheap if inflation surprises to the upside in the near future; and they’re cheap given our expectations for higher long-term inflation over the next decade.
Blueprint for a Successful Inflation Strategy
Given the heightened risk of future surges in inflation, the corrosive effect of inflation and the affordability of explicit inflation protection, we think investors should consider increasing their allocations to inflation strategies now. In our analysis, a 10% allocation to inflation protection—for example, shifting from a typical 60/40 portfolio to a 60/30/10 allocation—may meaningfully improve risk-adjusted potential return under the new inflation regime.
Adding explicit inflation protection isn’t the only tool at investors’ disposal. When it comes to inflation strategies, active duration management is imperative. For example, rising inflation typically leads to tighter monetary policy, higher real yields and lower TIPS prices. In that environment, a portfolio with a shorter average duration will be less sensitive to changes in interest rates but have the same degree of protection against inflation. After all, inflation protection on 30-year TIPS and one-year TIPS is identical. Active strategies can also adjust the amount of protection, depending on the outlook for inflation and the price of protection.
Investors don’t have to give up excess return over risk-free assets to get protection against inflation, either. Active inflation strategies may enhance potential return and outyield inflation by adding higher-yielding assets such as investment-grade and high-yield corporate bonds, securitized assets and emerging-market debt.
In our view, the right active inflation strategy should help investors beat inflation without sacrificing return. Between the low price of getting inflation protection today and the high cost of not having such insurance tomorrow, we believe the time is right to beat the inflationary tide.
1 As measured by TIPS breakevens.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to revision over time.
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