It’s one of the most well-known terms in economics. It is however a very broad subject. Countries have been in trouble as a result of inflation. Many central bankers aim to be called inflation hawks. Inflation can be defined as the rate at which prices rise over time. It is also usually defined as a wide measure of price increases or decreases in the cost of living in a country. It can, however, be computed more precisely for items, such as services or food.
The word “inflation” originally referred only to the amount of money. This meant that the amount of money was inflated and exaggerated. Using this word to mean “price increase” is a quick way around from the real cause of inflation and therefore the real cure for it. As the money supply increases, people can afford more money for a good. If the supply of a good does not increase (or does not increase as much as the money supply), the price of this good increases. As there are more dollars, each dollar decreases in value. The “Price” is therefore the ratio between dollars and units of a good. Thus, people devalue a dollar for more dollars. This makes things more expensive because there are more dollars. As long as we are caught up in the wrong theories and ideas about the causes of inflation, we will suffer from the wrong remedy. For example, those who attribute inflation primarily to shortage of goods are most likely to say that the answer to inflation is production. But this is at best half true. If the money supply increases faster, it’s impossible to lower the price by increasing production. The worst anti-inflation remedy is price fixing or fixed wages. If more money circulated and prices are kept low, most people would have an unused cash balance. Except for the same increase in production, the result should be a higher price.
By removing government-set prices and most things such as energy and food in terms of prices (which are mainly affected by seasonal factors or temporary supply conditions), the core consumer inflation focuses on the underlying and persistent trends in inflation. Policymakers are also keeping a close eye on core inflation. An index with broader coverage, such as the GDP deflator which is required to calculate a more global inflation rate.
A lax monetary policy is frequently the cause of long-term high inflation. The currency valuation decreases when the money supply grows too large in relation to the size of an economy. In other words, the currency’s purchasing power decreases and prices rise. The quantity theory of money describes the relationship between money supply and the size of the economy. It states that if the amount of money in an economy goes by twice, price levels will double as well. In a more practical way of saying, this means that for the same number of products and services, the consumer will spend twice as much. This rise in price levels will eventually lead to an increase in inflation. Inflation is therefore a measure of the pace at which goods and services in an economy rise in price.
As a weapon for reducing inflation, central bankers depend on their capacity to influence inflation expectations. Policymakers proclaim their plan to reduce economic activity in order to lower inflation in the short term, in the hopes of influencing inflation expectations. The stronger the impact of central banks’ pronouncements on inflation expectations, the more credibility they have. The supply restrictions that have bedeviled the US recovery show no signs of abating anytime soon, dragging on GDP and fueling inflation.
In summary, inflation is an increase in the quantity of money and bank credit in relation to the quantity of goods. It devalues the monetary unit, increases the cost of living for all, imposes taxes on the poorest at the same high rates as those on the richest, destroys all the value from past savings. It’s harmful because it discourages the future. It redistributes savings and income indiscriminately, it encourages speculation and gambling through frugality and labor, undermines trust in the fairness of the free enterprise system, and corrupts public and private morals (leading to ethical subjects).
Over the last few decades, stock valuations, measured in price-earnings ratios, have been strongly negatively correlated with inflation indicators such as the 12-month change in the CPI. This regularity persisted for at least the last few decades when such measurements were available if inflation was replaced with survey-based measurements of expected inflation. It is also resistant to price-earnings ratio corrections due to inflation-related distortions in book profits. In the current discounted value model, the negative correlation between inflation and price-earnings ratio means predicting either high long-term real equity returns with high inflation or low long-term real earnings growth (expected dividend payment ratio).
In a controversial analysis of inflation and equity valuation, Modigliani and Cohn (1979) documented a similarly negative relationship between price-earnings ratio and inflation in a selected sample. From quarterly data from 1953 to 1977, they found that prevailing inflation had a negative marginal impact on equity valuations, even after considering the negative effects of nominal bond yields. They acknowledged that such a relationship could reflect an inflation-driven risk premium on equities vs bonds but argued that it was difficult to explain the magnitude of the impact.
A more compelling explanation is that investors are plagued by some form of money illusion. Investors use stock income at an interest rate that corresponds to the nominal interest rate of the bond, rather than the economically correct real interest rate, which is the nominal interest rate minus the inflation premium. However, the Modigliani Cohn analysis assumes that long-term real earnings growth expectations are basically constant and imposes very specific assumptions on the structure of short-term earnings forecasts.
Investment in commodities is an idea that has been around since the 70s, but only recently has it become popular with institutional investors. Perhaps that is because traditional stocks and bonds have done so poorly in the last few years. Perhaps it is because investors have recently become more concerned about inflation, and they recognize that their liabilities will go up as inflation increases. Perhaps it is because investors recognize the potential diversification benefits that commodity offer. Or perhaps it is because they see other reputable investors who have committed to the asset class in search of potential benefits.
Commodities are fundamentally different from stocks and bonds. They are investable assets, but not investments. The goods do not generate dividends, interest payments, or other revenue streams that can be discounted to calculate the net present value.
We consider gold as special apart from commodities. This is a well-known inflation linked product and therefore important to separate from our commodity study. Gold underlying is quite an exception to commodities. Gold price is reacting positively to the growth but reacting negatively to inflation.
Bonds typically offer a set of fixed interest rate payments that are a percentage of the face value of the bond. As inflation recovers and prices rise, interest-paying purchasing power declines. In short, the purchasing power of these fixed payments is reduced. To mitigate the risk of inflation for bondholders, the US Treasury created the Treasury Inflation Protection Securities (TIPS) in 1997. These are bonds whose interest payments should rise as inflation rises. They are available for a period of 5, 10 and 30 years. However, there is a price to pay for TIPS inflation protection. TIPS are more expensive than traditional government bonds, and higher-rated bonds have lower returns than lower-rated bonds.
Real estate equity represents ownership of real estate, a participation in the operational and financial risks of real estate ownership, a participation in the gains and losses of real estate operations, and income from the sale of real estate. Real estate stocks compete with investments in stocks, mutual funds, venture capital and variable annuities. For 20 years (1990-2020), REITs have nearly quadrupled the S&P 500 Index, which contains the largest 500 capital in the US market. It is also important to note that listed real estate companies are heavily utilized for their industry.
Diversification is the practice of spreading our investments across multiple asset classes and underlying so that our exposure to any one asset type is limited. This practice is intended to help reduce our portfolio’s volatility over time. Diversification can help reduce the number and severity of stomach-churning ups and downs in our portfolio, potentially reducing the number and severity of stomach-churning ups and downs. It’s important to note that diversification does not guarantee a profit or protect against loss.
To define our framework, we will identify four regimes from a two-dimensional study. We will be using inflation and growth as key drivers.
As we are using two proxies (core and non-core inflation) to get the current inflation trend, we will build two portfolios based of these two signals. For each of these signals, we identify the current regime. We will then use this result to dynamically re-balance our portfolio on a daily basis.
We analyzed historical asset classes performances over the above four regimes to get an allocation strategy.
From the non-core, we got 180 regime switches from CPI YOY (non-core) and 167 regime switches from the CPI XYOY (core). Using a regime switch spectrum. We get a 10% number of regime switches increase from core to non-core. One of the reasons could be the uncertainty of the inflation changes. The core inflation is therefore more stable than the non-core. This confirms that the core inflation is less volatile than the non-core inflation proxy. Nevertheless, we can already anticipate a slight difference on the portfolio re-balance frequency: the non-core inflation portfolio based will have a lowest re-balance frequency than the core inflation frequency. If each of portfolio performances is the same, we will have to consider the core inflation portfolio due to transaction fees.
Using CPI as proxy of inflation give us interesting results. From 1993 to early 2004, the portfolio is not too volatile. Cumulative return evolution is smooth. During the 2008-2009 period, we get a big dip from our return, losing our created value since early 2004. Compared to big index loses, our none core portfolio didn’t lose much. As expected, our portfolio is acting as a shield. Nevertheless, because we are fully invested in the market, we are exposed to both inflation and growth. Small reactions are therefore expected.
Using core inflation as a proxy of inflation gives us quite the same results as of the non-core portfolio for the 1993-2004 period. Smooth and under-reacting the CPI and the growth index. It’s important to note that this portfolio has a different re-balance frequency, making it less sensitive and with a lower turnover than the non-core portfolio. From the 2008-2009 crisis, we observed that we reacted quite well to the dip. This portfolio lost a year of return before having a big bump. As an intuition, this portfolio seems to be reacting quite well when the CPI is making big dips. (see Figure 4).
Considering inflation in portfolio management is usually not a central pattern while setting up a strategy. Being exposed to inflation is therefore a risk factor to manage. Inflation is the consequence of hundreds of economic and political decisions and phenomena. As a result, this metric is watched by not only financial institutions but by government and other big entities. The economic growth is one of the cornerstones of a country economy. In this paper, we made the choice to stick to a two-dimensional study to highlight how powerful and significant are inflation and growth. We came up with a portfolio investment strategy based on these two factors. To get deeper insights into inflation, we compared the non-core inflation and the core inflation. We took the consumer price index (CPI) as a proxy of inflation. Then, we identified historical inflation / growth regimes with four different possibilities from a two-dimensional study. We chose to manage our risk through diversification by selecting different asset classes (Equities, Commodities, Gold, Real Estate and Treasury). As we are using historical data to select our assets classes and to compute our weights, we expected a good return using the same data to back-test our portfolio. Past performance is no guarantee of future results is key to know (see Figure 5).
If we wanted to extend this regime identification algorithm to a model, we could build a hidden Markov model (HMM). This model would be able to identify our next allocation move with computed probabilities. We usually find these types of models when running a regime switching analysis.
Overall, the core portfolio seems to be performing quite well compared to the other ones. If we have invested in the SPX, we would have approximately the same expected return but a higher volatility and therefore higher risk compared to the core portfolio. The Non-core portfolio have a similar Sharpe ratio as the SPX. The previous studies showed that the non-core portfolio was giving more stability. Thus, less uncertainty thanks to diversification which is the key
Inflation and growth are two watched and important indicators in macro economy. They affect everything. Getting great portfolio results using macro phenomena is interesting since we are not using direct market indicators. To conclude, it is obvious that inflation is becoming increasingly important in the study of an asset portfolio. Indeed, it is a significant risk factor. Not to take inflation into account is to deliberately ignore economic phenomena that affect any person, entity, small or large company, economy, or country. n
