As the dreaded ‘s’ word edges onto the periphery of economists’ radar screens, Martin Steward assesses the options for defending against it - and the risks those options present
Research suggests that the people who survive disasters are the ones who located the life jackets and fire exits, followed safety drills or paid attention to cabin crews’ pre-flight workouts. The insouciant all too often freeze and perish.
It is in that spirit that IPE considers stagflation risk. “We’re used to cruising at 35,000 feet,” says Andrew Slater, managing director in pensions risk management at Ortec Finance. “But the most dangerous points in a flight are take-off and landing. Stagflation might be considered an extreme risk, but it is in the empirical data, and the 1970s is not ancient history.”
Ed Peters, co-director of global macro at First Quadrant, reckons that conditions prevalent before that last bout of stagflation overlap today’s by about 30%. “That’s not trivial,” he observes. JPMorgan Asset Management is pretty consensual in seeing it as a risk but not a core scenario: disinflation is its base case, at 55% probability, while deflation is set at 25%. It reckons that there is a 20% chance of inflation over the next 18 months, split 60/40 in favour of stagflation against rapid growth. That puts the overall chance of stagflation at about one in eight. Again, that’s not trivial.
It’s easy to delineate the ‘stagnation’ part. Corporates have a lot of de-leveraging to do and the banks that would otherwise be providing their credit lines have even more. That’s before we even get to consumers, who are too busy paying down credit cards to buy anything. Western governments’ indebtedness could lead to increasing tax and regulatory burdens and protectionist measures that smother external trade and prop up zombie companies. The jagged inventory cycle - currently jumping because producers had de-stocked way below the level of sales - fools no-one: the consensus is for retrenchment of productivity during 2010.
That under-utilised capacity is one reason why disinflationists do not believe governments’ huge liquidity injections will feed core inflation. They also point to the importance of wage inflation during the 1970s: capital has won its battle with labour since then; and many of this cycle’s job losses look permanent. This is classic Phillips curve analysis - which inflationists think is flawed. Empirical evidence for the correlation of inflation and capacity utilisation is actually weak, they argue, because inflation is a monetary phenomenon that isn’t dependent on growth.
“We still haven’t had a negative month for core inflation in the UK or US,” observes Percival Stanion, head of the asset allocation team at Baring Asset Management. “If you can’t get negative inflation with this recession, when are you going to get it?”
Barings expects inflation to hit 3-4.5% over the next few years. Others talk of ‘high single-digits’. Many more agree that inflation has bottomed out. Australia’s rate hikes, the weakening dollar and gold’s new highs look like straws in the wind. October has seen US 10-year breakeven inflation rise 30bps, to more than 2%. Similar levels can be observed in eurobonds and UK swaps show inflation peaking around 4%. Meanwhile, according to Swiss alternative investment specialist Partners Group, Harvard and Yale have both significantly increased their allocations to real assets to almost 30%.
What would stagflation do to a portfolio? One thing seems pretty clear. As JPMorgan Asset Management’s global strategist Rekha Sharma puts it: “Bonds would be absolutely decimated.”
Last time around, US CPI nudged 15% and rates were hiked to 20%, pushing 10-year yields out to almost 16%. Corporate bonds fared even worse, despite a relatively benign default rate. Things got so bad that traders ruefully nicknamed bonds ‘certificates of confiscation’. Furthermore, bond volatility tripled and started to look like equity risk. “Most strategic asset allocation decisions are based on bond volatility at 3-4%,” notes Peters at First Quadrant. “I don’t see anyone preparing for that risk of a dramatic increase in portfolio volatility.”
It’s all about duration: curve-flatteners should pay off handsomely and in long-only terms, the shorter the better. “Cash would become a viable asset class again,” says Peters. “In one of our strategies we use cash instead of TIPS (Treasury inflation-protected securities) to give us some inflation protection,” agrees Scott Wolle, CIO at Invesco. “In the 1970s we saw equities, bonds and commodities struggle, but cash yielding 12%.”
Cash instead of TIPS? Wolle says he’d rather rely on an asset with centuries of data points than one that really only got going in 1981 - after the last bout of stagflation. On the face of it inflation-linked coupons look ideal, and if you don’t mind drifting from your liabilities, global inflation-linked would be great for hedging globalised inflation (such as cost-push through commodities). If it had a monetary tinge for your home currency, you could take the FX risk, too: sterling-based investors can take their pick, but even euro-based investors might fancy their chances on Australian or emerging-market local-currency linkers. The danger is in the unpredictability of real yields.
“Although the coupon will protect against inflation, your long gilt will suffer a lot of negative short-term mark-to-market effect,” says Mauro Ratto, CIO at Generali Investments.
Arguably, this would only really happen in an environment where inflation is quite high and is expected to remain structurally high. Then, a sell-off at the long end of the nominal curve might eventually compensate for those stable inflation expectations, sucking capital out of linkers and pushing up long-end real yields. If you buy long-dated linkers today, hoping for at least some capital growth while real yields are so low, that’s going to hurt. Is that scenario realistic? Probably not. As Nick Sykes of Mercer Investment Consulting observes: “If inflation is at 5%, then it must have got away from policymakers, and therefore could go to 7%, 3% or anywhere.” While expectations remain volatile, nominal yields will likely continue to rise to compensate for upside inflation risk, while real yields edge downwards. Either way, the inflation-linked coupon will make the ride on a linker less volatile, and the cautious can hedge their mark-to-market risk with nominal futures.
That does not address the pure valuation question: how much lower can real yields go? John Stopford, co-head of fixed income at Investec Asset Management, notes that TIPS real yields imply only about half the 1.5% headline inflation rate he expects for the next two years, while UK linkers are pricing in about 2% RPI, against his estimate of 3-4%.
While he concedes that US and UK real yields look low in absolute terms, he argues that they do not relative to nominal yields. “Trades that go long the former and short the latter look especially attractive,” he suggests. This is another way in which it pays to shop globally for linkers: real yields in Chile or Poland look compelling alongside the UK’s or much of the euro-zone’s, for instance.
In terms of supply and demand, governments continue to prefer nominal issuance and net redemptions of linkers look set to increase, while the bottoming-out of headline rates suggests that linkers will become more, not less popular. “Real yields are towards the high side for this point in the cycle,” says Elwin de Groot, senior markets strategist at Rabobank, “but to me that’s a sign that the market has turned and a lot of investors want inflation protection.”
Moving along the risk spectrum from cash and linkers, investors might like to follow the US endowments and head into real assets. Commodities seem like the obvious place to start, except that beyond the very short term, correlation between commodities and inflation tends to break down. First of all, cost-push inflation depresses economic activity and forces commodity prices back towards equilibrium. Secondly, commodities only look attractive as long as central banks remain behind the inflation curve. Once they get ahead of it, real and nominal yields overtake commodity price momentum.
Commercial real estate, with inflation-indexed rents, demonstrates much more robust long-run correlation with inflation, with more attractive yields than index-linked bonds. Of course, the pricing of that risk premium is key: index-linked rents are all very well until the whole world goes out of business, leaving your warehouses and offices vacant.
“If 90% of the economy remains intact, you’d expect most real estate cashflows to remain intact,” says Sykes. “More damage might cause difficulties at the margin.”
That is a consensus view. Real estate has been so badly punished already that most of the bad news is already baked into yields. By the end of next year, most investors agree, they should finally be topping-out. “There’s been a phenomenal repricing of risk over the last nine months,” notes Robert Brown, chairman of the global investment committee at Watson Wyatt. “But real estate yields have continued to back out, thanks to doubts about rents and the real economy.”
The range suggested to IPE put 10-year yields on commercial property at around 9%, factoring-in a 10-15% drop in rents. Defensive assets could trim some of that rental default and push yields into double figures, as could global property secondaries picked up from forced sellers. Another inflation-linked real estate play to consider is farmland, which proved to be a winner in the 1970s.
Infrastructure also offers inflation-plus tariffs, and it might be argued that the core end of infrastructure risk presents less danger of under-utilisation than commercial real estate (although yields look commensurately less attractive).
All of these options can involve leverage, so perhaps the biggest risk is that of central banks hiking rates. “If your cost of financing goes up and you get some vacancies you get squeezed,” notes Sykes. “It’s potentially the worst of all worlds.”
Convention regards equities as an inflation hedge because they are a claim on the dividend stream of real assets. But convention didn’t stop them going to the dogs in the 1970s. Inflation pushes up both volatility and discount rates on future cashflows: risk premia go up, returns come down. Demand-pull inflation increases pricing power and margins across the board, but cost-push inflation has the opposite effect.
For stagflation, where inflation probably comes from cost-push and currency depreciation, the prescription seems fairly clear: outperformers will be able to protect top-lines through super-robust pricing power, particularly if they export into markets with appreciating currencies. That could be a very elite list - but it would go beyond high-dividend, high-growth defensives.
“If it’s a global issue, there’s not much you can do. But if it’s a UK-specific issue then I’d want exposure to overseas earnings, especially emerging markets,” says Ashton Bradbury, head of equities at Old Mutual Asset Management. “The best performing UK banks have been HSBC and Standard Chartered. In beverages, the best performer has been SABMiller, with 50% exposure to emerging markets. You see the same in support services.”
Matthew Rubin, Neuberger Berman’s director of investment strategy, paints a similar picture. “You’d want to own companies in industries with barriers to entry, and strong pricing power and free cashflows to finance their own growth,” he says. “Some of these opportunities could be found within the cyclical sectors.” At Barings, Stanion says that equity portfolios remain tilted thematically to commodity-related stocks. They were the only outperformers in the 1970s, and now there is a further argument in their favour: “It’s partly just because demand from the East is a longer-term theme.”
Interestingly, these portfolios would still look pretty robust if we found ourselves in the consensus scenario of low growth and moderate inflation. A stagflation portfolio would be more underweight equities overall but, within that, emerging markets work in both instances, as does growth (the risk there comes from stagflation, which might see growth underperform as discount rates on future cashflows shoot up). But most intriguing is the issue of balance sheets. Under low growth and moderate inflation, low levels of debt look attractive; if growth gains traction and rates rise, it looks even more attractive. But with stagflation there is a chance that leveraged companies could watch inflation eat away their debts, while interest payments remain low because central banks are paralysed by low growth. The same potentially applies to leveraged real estate or infrastructure assets.
It is easy to assume that stagflation simply means high inflation, which central banks will chase with rates. But what if they do not? Suddenly a portfolio full of cash and curve flatteners looks like a complete disaster as commodities and other real assets are set free on a wave of momentum and leveraged companies’ balance sheets magically heal themselves. Among ‘low-risk’ stagflation assets, only linkers would benefit.
“Central bank reactions would be key to asset allocation,” says Keith Wade, chief economist at Schroders. “If they respond, you want to be in cash. If they let the whole thing go, you want commodities and index-linked bonds.” With Western governments so badly indebted, and the evidence from the past 12 months of their close co-operation with their central banks on stabilisation and industry bailouts, it would be foolish to bet against the latter. Société Générale recently calculated that 10 years of 4% inflation would cut debt by one third.
Still, the consensus holds that inflation will fail to gain traction. As we have seen, that would pose few problems for a stagflation-primed equity portfolio. But again, it would be very bad for cash and curve flatteners, and also nasty for inflation-linked bonds relative to fixed income. Commodities would underperform as prices would ultimately be capped by soft demand. The danger here is of a ‘stagflation trap’, as higher commodity prices in the near-term - thanks to momentum and emerging market demand - coincide with softening numbers from the Institute of Supply Managers as the inventory cycle exhausts itself.
“It’s difficult to imagine G7 growth falling dramatically while the commodity complex goes off to the races,” says Matthew Merritt, head of investment strategy at Insight Investment. “For the UK and the US, however, a stagflation scenario might look very convincing into the beginning of 2010. We may well play that - but it’s likely to be a trade for a couple of months rather than something we would sit on.”
This is really the nub of the problem. So few investors have stagflation - or indeed deflation - as their central scenario, and yet most concede that the probability of those two tail events has gone up and remains evenly balanced. “Hedging those asymmetric risks is costly and a very black-or-white decision,” notes Andrea Rabusin, CIO at Generali Investments. “If you believe in inflation you’d sell nominal bonds and buy real assets. If you believe in deflation you’d do the opposite.”
What investors need is optionality and convexity on the tail risks. Pure optionality is available in the form of inflation and interest rate swaptions, or inflation caps and floors. Demand for interest rate swaptions at around 2% over current forward rates has picked up in recent weeks - but that has pushed up volatility and pricing, and these things are pricey at the best of times.
“Pension fund clients are thinking more and more about covering those extreme-risk but low-probability scenarios with optionality,” confirms Emiel van den Heiligenberg, head of asset allocation at Fortis Investments. He suggests controlling costs with cap-spreads. Buy an inflation cap at 5%, and you receive any inflation beyond that threshold; sell an inflation cap at 9% and you pay any inflation above that threshold. You get protection between 5% and 9%, using the theta you receive from the contract you sell to pay off at least some of the theta on the contract you buy.
This is particularly good for schemes whose liabilities are linked to inflation but capped at a certain rate. They can buy protection up to the cap and sell protection above the cap to pay for it. The inflation they pay out if it edges higher is offset because it no longer affects their liabilities. Forecasts for medium-term inflation come in at around 4-5%, just under the 5% compounded rate used as the cap for UK pension liabilities, so cap-spreads could be ideal.
This pure optionality leaves consensus portfolios largely untouched. But it is worth remembering that optionality doesn’t always have to be about options. We have already seen that a consensus equity portfolio contains a lot of embedded optionality on stagflation, as does commercial real estate at its current yields. Gold should be considered as a source of both optionality and convexity, as it tends to benefit from inflation, deflation and other extreme environments. But the ultimate convexity is, of course, achieved simply by being nimble enough to respond to events, and the case for diversified tactical asset allocation and global macro funds looks strong from this perspective. Global macro, in particular, is set up to exploit extreme economic environments, and generally underperforms only during periods of combined low growth, low inflation and, especially, low volatility: while the first two are the consensus for the next couple of years, no-one predicts low volatility.
So it is possible to prepare for disaster without locking yourself indoors and missing out on life. Optionality and convexity are important - as is old-fashioned value. The greatest risk, by contrast, lies in static asset allocation based on the economics of the ‘great moderation’, or the assumption that we are still “cruising at 35,000 feet”.