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How to Prepare for Inflation’s Inevitable Return 

Steven Malin 

 

Steve Malin

7/19/2017 

Inflation is being suppressed as long-standing economic relationships – such as the linkage between labor-market tightness and wage growth – have broken down. But Steve Malin says inflation will inevitably return and investors will have to be ready.

Key Takeaways

  • Unconventional monetary policies since the Great Recession may have restrained inflation inadvertently
  • Emerging-market development has kept inflation low since the end of the Cold War, yet this factor has frequently been overlooked
  • Eventually, aggregate demand should catch up with supply in a balanced and sustainable way, and inflation could move higher
Powerful interactions between domestic and global forces continue to suppress inflation rates around the world. Meanwhile, long-standing economic relationships – such as the linkage between labor-market tightness and labor compensation – have adjusted or broken down. Case in point: The persistent decline in the US unemployment rate – from 9.8% in 2009 to 4.3% today – has not resulted in commensurate increases in wages.

An ongoing search for inflation

So where has inflation gone? Unfortunately, we have only partial answers. Unconventional monetary policies since the Great Recession may have restrained inflation inadvertently. When central banks bolstered aggregate demand, they also strengthened the supply side of markets just as much or even more. Global markets became awash in goods, providing a disinflationary global supply glut that has been stifling inflation.

To be sure, there were several entrenched structural trends that also contributed to persistently low inflation rates, including reduced consumption from ageing baby boomers; a growing disparity in wealth and income; and high-tech innovations that change the way some businesses produce and distribute goods and services.

There has also been a frequently overlooked factor keeping inflation low since the end of the Cold War: emerging-market (EM) development. EM investment in capacity expansion and productivity enhancements blossomed to a record 25% of global GDP by 2015. This squeezed out private-sector investment in developed-market (DM) economies when "renting" capacity in low-wage countries became less expensive than building it. As a result, long-lived equipment from the least expensive EMs did a better job of keeping costs down.

Ending the Cold War also "freed" roughly half of the global population to compete in international markets. An additional three billion workers now compete directly for jobs held by DM workers. Since these workers can stash some of their earnings in saving accounts for the first time, output markets have been experiencing an ever-growing supply without a commensurate increase in demand. As a result, there has been a glut of unplanned inventories and productive capacity.

Planning for inflation's eventual return

We believe aggregate demand will catch up with supply in a balanced and sustainable way, and the inflation rate will anchor at a higher level. This may be brought about by more sustainable population growth, better fiscal policies, tax reform in the US or the growing EM middle class. The age of oversupply should not go on forever, and at some unknown point in the future, inflation could become "demand-pull" inflation.

Meanwhile, some investors have begun to consider their vulnerability to a higher price level – and how to protect their portfolios. Of course, since adding inflation protection to a traditional asset allocation is unlikely to improve expected returns, some investors choose not to do so at any price – at least until they can "see the whites of the eyes" of an accelerating inflation rate.

Eight principles for fighting inflation

Investors who decide to hedge against inflation risk would be prudent to act upon some of the following principles:

  • No individual asset class or strategy can provide the optimal inflation hedge. Many different assets can provide some protection, but their ability to do so reliably varies. Optimal inflation hedging requires a diversified mix of asset classes.
  • In determining the asset mix for optimal inflation protection, prudent investors pay attention to how closely their assets match their liabilities. The more liabilities increase with inflation, the greater the exposure to inflation – and the greater the need for prudent protection.
  • Pension plans without benefits indexation require less exposure to inflation hedges, while plans with indexed benefits have significant inflation-related liabilities and need more protection.
  • Allocation even to lower-returning inflation hedges may be sensible as pension plans become more under-funded.
  • Income-related assets (such as an individuals' future wages or an endowment's fund-raising potential) benefit from rising inflation and provide a natural inflation hedge. Investors with fewer such assets generally need more inflation protection.
  • For individual investors, the average allocation to inflation protection tends to rise with age, even for those with only moderate risk aversion, reflecting diminishing future income streams as they move through the life cycle.
  • Drivers of inflation protection differ between investors with and without capital in excess of what they need to support their spending needs. Investors with little excess capital tend to demand much more inflation protection.
  • For all individual investors, the tax-efficiency of inflation hedges varies and influences the timing, composition and magnitude of portfolio adjustments. If inflation protection cannot be sourced without undue tax consequences, investors might consider curtailing, or even foregoing, portfolio adjustments to hedge inflation risk.
The decline of break-even yields continues

Over time, the yield that investors would need to outperform inflation using a Treasury inflation-protected security has fallen

Break-Even Yield Chart

Source: Bloomberg and Allianz Global Investors as at June 16, 2017.
Chart author: Hans-Peter Rathjens, Allianz Global Investors Economics & Strategy.
The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.



Allianz Global Investors Distributors LLC, 1633 Broadway, New York, NY 10019-7585, us.allianzgi.com, 1-800-926-4456.

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