After decades of low inflation and a long period in which
investors questioned the need for inflation-associated assets, the specter of a
sustained bout of inflation has put protection front and center in clients’
minds.
In our experience, most economic models of inflation have
historically offered limited value to investors. Inflation can be incredibly
hard to forecast — central bankers and investors alike have not always gotten
it right. It can sneak up on the unprepared, so we believe that the best way to
protect against it is by viewing inflation-linked assets as a strategic
“insurance policy” in a portfolio. Like any insurance policy, there's an
opportunity cost.
Who should have inflation protection? Our analysis suggests
that it's not necessary for all investors but should add value for highly
inflation-sensitive clients. Those who are less sensitive may still benefit,
but their decision is not as clear-cut.
What makes a client highly sensitive to inflation is a qualitative
assessment involving a few important characteristics. First, it’s a function of
a client’s risk tolerance, most directly visible in their stock-bond mix. It
also depends on the amount of human capital they can convert into financial
capital over time (for instance, whether they are working or retired). Finally,
the decision hinges on their planned spending rate. Other factors, such as
long-term, fixed-rate debt like a mortgage, as well as idiosyncratic exposures,
can also affect sensitivity, but to a more modest degree.
We recognize that each person’s sensitivity is unique as one
person’s largest spending category varies greatly from another’s. Determining
sensitivity is not formulaic, but rather involves a discussion around the
tradeoffs.
How much benefit does inflation protection offer? Consider a
highly inflation-sensitive investor — a retired 65-year-old with 70% of her
portfolio in bonds and 30% in stocks spending 3% of her portfolio per year and
aiming to maintain that spending in real terms.
Using our proprietary Wealth Forecasting Analysis, we find
that, for this particular investor, inflation protection offers a substantial
benefit. The most striking finding in our analysis is that if she faces hostile
markets without shielding her portfolio from inflation, she will run out of
money by age 95.
That makes sense. But less intuitively, it's not just the
bottom end of the range of outcomes where she benefits — her performance
improves at the top end of the spectrum as well. By securing significant
benefits in inflationary times without sacrificing too much in non-inflationary
times, and with the backdrop of low nominal rates, her performance is likely to
be improved across the board. Essentially, she hasn't just eliminated poor
outcomes, she's shifted up her entire range of potential future returns.
For a less sensitive investor, though, inflation protection
offers less impact. When we consider a 45-year-old investor holding 70% stocks
and 30% bonds and look ahead 50 years, there's still some benefit in hostile markets,
but not nearly as much. And there's a slight cost in more typical or great
markets. This investor benefits marginally from inflation protection but may
justifiably choose to forego it.
For investors who don't fit neatly into these categories,
the most important indicator of their sensitivity will be the stock-bond mix. A
retired client with substantial equity holdings will appear more like the 45
year old and a client who is still working and has a heavy bond allocation will
appear more like the 65 year old.
When it comes to the protection itself, our preferred hedges
respect a client's risk allocation and which assets are being replaced. By
replacing a portion of a client's fixed income allocation with real bond
strategies rather than nominal bond strategies, we can add that element of
protection without distorting the portfolio's expected volatility.
At the same time, even for bond-heavy investors, by
replacing part of their equity exposure with a combination of stocks with
pricing power, real estate, real assets, and inflation break-evens or swaps, we
can incorporate upside from inflationary environments while maintaining
higher-than-expected returns across the full economic cycle.
Furthermore, for accredited or qualified investors,
alternative asset classes like core real estate or middle market direct lending
can offer valuable protection through their high cash flow, floating rate
investing structures. For any given client, this type of balanced inflation
hedge is likely to be more reliable and robust than an allocation solely to
TIPS or gold or agricultural futures. Diversifying exposure across multiple
inflation-linked asset classes is our preferred approach.
Bernstein Private Wealth Management has always recognized
the extent to which inflation can wreak havoc for certain investors. Now that
the markets are increasingly cognizant of that risk, it's a perfect opportunity
to remind clients how to consider their inflation sensitivity and, if
necessary, to protect against extended bouts of high inflation through a
measured strategic allocation approach.
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