Inflation has been prevalent in food prices, housing, energy and education in the developed world over the past 15 years. However with the level of monetary and fiscal stimulus in most developed economies, there is uncertainty around future inflation over the next 10 years or so. We were pleased to have Michael Underhill, Founder & Chief Investment Officer at Capital Innovations, LLC and Keith Black, Ph.D., CAIA, CFA at Chartered Alternative Investment Analyst Association present ”Protecting your portfolio from inflation,” to a CPBI audience last Thursday, March 17th. Mr. Underhill said inflation makes it more difficult to meet terminal wealth goals in nominal terms. Examples of investors subject to inflation include: foundations with a real spending target, pension plans that offer cost-of-living-adjustments to their retirees, and corporations or entities with fixed incomes but with expenses that move up with inflation. Entities looking to avoid erosion of capital in real terms typically chose a larger allocation to real assets in their investment mix with allocations ranging from 5 to 20%. Included in the real assets category is farmland, timber, commodities (energy, metals and oil), real estate and infrastructure. Investors have also invested in assets such as inflation linked bonds and commodity futures to get exposure to assets that protect against inflation. According to Mr. Underhill, 10 year US Treasury Inflation Protected Securities (TIPS) has historically not kept up with inflation despite falling level of interest rates over last 15 to 20 years. Equities Mr. Underhill highlighted equities as an asset class that historically have high long-term returns but over the shorter periods can suffer from higher interest rates during times of inflation, unless the equities are specifically linked to real assets (natural resource, energy or real estate sector). Real estate and Timber, Farmland, Real estate is an asset class that is a good hedge for inflation depending on the structure of income (rent and renewals) and how much leverage (mortgages, etc.) there is on the assets. While land values for timberland can be negatively affected by high debt, the raw material (i.e., the actual timber) is positively correlated with inflation. Other factors such as supply and demand (from housing starts) etc. can affect pricing. Depleted resources (lack of replenishment or replanting) in both Sweden and Russia and natural hazards like the pine beadle problem seen in British Columbia, are all factors that have led to scarcity of timber which affects demand and in turn prices to move up. Farmland has very good inflation protecting characteristics although there are risks such as lack of fresh water which may affect returns going forward. Infrastructure & Master Limited Partnerships (MLPs) Toll roads, pipelines, ports and utilities can benefit from inflation when user fees increase at a greater rate than expenses. Toll roads and ports can be more susceptible to the economic downturns and swings in manufacturing/production or capacity. For many infrastructure assets the cash flows are typically recession proof or more steady in nature. Commodity Futures This asset class saw significant inflows (USD 400 Billion) in the previous decade up to 2010, and has since then seen significant outflows (US250 Billion) according to Keith Black. Commodity futures have a positive correlation to inflation compared to bonds and equities which exhibit opposite characteristics. Based on index performance risk-adjusted returns over a 20 year period, commodities are not nearly as attractive as equities and therefore Mr. Black suggested timely tactical allocations may be the best approach for this asset class. Commodities tend to outperform at the top of the business cycle while equities are more of a leading indicator. In the short term Mr. Black pointed out there is not always a link between the prices of commodities and commodity stocks. The prices of many commodities are tied to demand in Asia. China has played a major role in the commodity demand with a government that invested heavily in infrastructure for a long time and 290 Million people moving into the cities. Mr. Black suggested now that China is moving from an industrial economy to a consumption economy and that India could be the next country to “take over the baton” in terms of infrastructure spending. In the US oil supply has started decreasing as a result of lower prices. Globally however the inventories are higher than ever if looking at Organization of Petroleum Exporting Countries (OPEC) levels (Millions of barrels per day). In a nutshell, higher supply and lower demand in addition to a strong USD are all factors that helps explain the lower oil prices seen the market today.
Certain real assets have proven inflation protecting characteristics over time. Their prices and returns going forward however may depend on supply and demand and/or be affected by a number of external factors such as interest rates, natural hazards and economic environment. Historically real assets have added diversification to portfolios using only traditional asset classes. - Stian Andersen Please visit our WordPress Blog for a copy of the presentation |