If inflation persists, which diversifiers could work and what mistakes may occur?

1. What if rate cuts are delayed or inflation re-accelerates?

In the past few weeks since the start of the Iran conflict, the strategic importance of energy production, infrastructure and transport has reminded investors and consumers alike of the critical role of hydrocarbons in the global economy. The knock-on effects are real, driving prices higher on almost everything from airfares to fertilizers and food. Inflation is front-and-centre, yet again, and bond markets have done an about face. At the outset of the year, having assumed inflation was in-check and thus anticipating rate cuts to stimulate a lagging economy, interest rate futures markets have recently begun to price-in the likelihood of one or two rate hikes before year-end (on a still lagging economy). Inflation, and its impact on interest rates is a very real conundrum for consumers and borrowers alike, but also a critical moment for investors holding habit-formed portfolios.

2. If that occurs, which diversifiers tend to help most?

As investors grapple to capture gains associated with these themes, this translates to a “bet” as to how long the Iran conflict continues to disrupt energy markets. In our research on portfolio construction, the importance of “hard-wiring” inflation-sensitive returns into investors’ strategic asset allocation reminds us that inflation is difficult to predict; not just in terms of timing, but also in terms of magnitude and “stickiness” (i.e. the knock-on effects). Balanced investors tend to revert to playing “defense” in portfolio construction, shortening duration to limit the sensitivity of fixed income allocations to the level and direction of interest rates. At PICTON Investments, our multi-strategy approach argues investors can play offense, harnessing inflation-sensitive returns, but this must be done prudently. We believe commodities could offer the opportunity to garner inflation-sensitive returns, but as a broad asset class, they are historically volatile. Other diversifying assets and strategies can play a role (i.e. inflation-linked bonds, where duration risk is hedged), but a thoughtful and risk-aware approach to allocation is required.

3. What’s the most common mistake investors make when adding those diversifiers?

We have identified that commodity asset classes tend to offer greater sensitivity to the trend and level of inflation. While there are other assets and strategies to employ in an effective inflation allocation, investors tend to focus on the primary cause or beneficiary of inflation…in this case, the energy complex. Understanding the volatility of energy commodities, especially in the current context, perhaps the most common mistake investors generally make is in sizing their allocation. Yes, timing is a risk, because, as noted, these episodes are hard to predict, but when commitment is made, investors often over-index to “what is working”. Instead, the primary focus in portfolio construction should be on achieving diversification benefits. Allocating to commodities and other inflation-sensitive assets and strategies often requires a diversified approach, where contribution to portfolio risk is a higher consideration than simply chasing returns. As an adjunct, it is also important to not compound, or muddy the allocation’s intent by adding equity beta in the form of commodity producers. While higher commodity prices could provide operating leverage, a variety of business risks must also be considered, not the least of which may be the rising cost of producing the commodity in question (i.e. energy is an input cost to many metal mining operators). Last, having a process to effectively scale positions ensures volatility can be mitigated by re-weighting allocations based on trend, especially in times of heightened volatility.

4. Has the stock-bond correlation changed?

This is perhaps one of the most important portfolio construction imperatives we have discussed in the past few years. For the past few decades, many investors have come to rely on the fact that stocks and bonds generally held a low correlation, with the expectation that one effectively “hedged” the other in a typical “balanced” portfolio. In reality, for the past several decades, investors enjoyed a Goldilocks environment of low-and-stable growth, with inflation very well-contained, which allowed for progressively lower interest rates through an extended period of time. Generally speaking, those decades saw bonds offer a massive total return tailwind for balanced investors and did well to buffer equity risk in periods of economic growth shocks. The trouble is, bonds don’t offer a similar ballast during periods of inflation shocks, the likes of which we are experiencing now. We have also noted that in periods where inflation lies at or above 3%, stocks and bonds become more highly correlated and this current episode sees this reality ringing true yet again. This is a crucial point for the so-called “balanced” investor…when stocks and bonds misbehave together, portfolio diversification may benefit from inclusion of more diversifying assets and strategies.