The Case for Adding Inflation Protection to a 60/40 Portfolio

June 18, 2015

The Case for Adding Inflation Protection to a 60/40 Portfolio Photo

Yiwei Tang contributed to this post.

Last week, I came across a research report written in 2009, its main point being that "quantitative easing" (QE) is equivalent to printing money and will eventually lead to inflation. The author was recommending short position on U.S. Treasuries.

The author was right in that QE is printing money; however, if printed money doesn't flow into the real economy, the impact on inflation will be minimal. This is what's called a "liquidity trap," something that has kept inflation at bay since 2009.

Currently, the Fed's major concern is not inflation but disinflation, a decrease in the rate of inflation. Because the market worries more about disinflation, assets that tend to outperform during inflationary environments are trading more cheaply. Take a look at the 10-year TIPS (treasury inflation protected securities) breakeven rate, precious metal miners, metal/mining, energy producers or banks. They are all trading at historically attractive levels.

Now let's take a look at the two major forces behind the secular deflation:

  1. Demographic: The world is aging, and if you were to use Japan as an example, its view is that an aging population means lower inflation. The research doesn't support this view. In fact, because the portion of the population working shrinks in an aging society, labor may get more expensive and cause inflation.
  2. Technology: The general view is that technological advances disrupt the economy and reduce the cost of many services dramatically. However, there are two types of innovations. One allows us to do things more efficiently, and the other allows us to do things we could not do before. The first type of innovation is deflationary, while the second can be inflationary. For example, recent progress in immunotherapy holds promise of curing many cancers a decade or two from now. Who will pay for these expensive therapies? How will society pay for the care of elders when advances in healthcare allow more and more people live beyond 100 years? The impact of technology on the economy is not as clear-cut as people think.

Based on recent economic news, the cyclical forces behind deflation are slowly fading. The number of U.S. job openings in April was 5.4 million - the highest level since 2000. The increase in average hourly earnings reached a cycle high of a 2.3% annual rate, and the employment cost index rose to 2.6% annual rate. In addition, retail sales are robust and spending in restaurants is up 8% year-over-year. Auto sales are close to all-time highs at 17.7 million units per year. All of these are indicators that consumers are more confident and ready to spend. With energy stabilizing, disinflation has probably bottomed in this cycle.

To build a balanced portfolio, we want to have assets that can perform in different economic environments, and we want to accumulate them when they are cheap. When treasury yield is close to historical lows and equity valuation is close to historical highs, inflation becomes a threat for a traditional 60/40 equity/bond portfolio. Adding some inflation protection will improve the portfolio risk profile.

Key Takeaway: The market clearly has little concern about inflation, as assets traditionally viewed as inflation protections are cheap. Because higher inflation can cause higher interest rates and lower risk premium for equities, adding some inflation protections can improve the risk profile of a traditional equity/bond portfolio. Ultimately, the risk is an economy similar to the deflation Japan has seen over the past decade. However, with the Fed's concern over disinflation, I think the probability is low for an extended period of disinflation/deflation. If history is any guide, the odds are on inflation's side.

Tags: Chart of the Week | Bonds | Stocks | Inflation | Portfolio | Deflation | Quantitative easing | Japan | Disinflation | Demographics

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