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Income Investing

Inflation considerations: preparing income portfolios for the next risk

Anders S. Persson
CIO of Global Fixed Income
Nathan S. Shetty
Head of Multi-Asset
Brian Griggs
Portfolio Strategist
Inflation considerations

Highlights

Income investors are facing a risk that hasn’t been an issue for decades: inflation. As the world emerges from the coronavirus pandemic, inflation pressures are on the rise. How can investors manage the possible risks while also positioning portfolios to take advantage of the shifting environment?

[Interested in learning more about inflation-sensitive assets? Download now to read more.]

Are inflation fears warranted?

Already this year, inflation has reached 5% year-over-year. While this level exceeded expectations, keep in mind that the percentage change was calculated from a low base. The last 12 months included a period of rising prices, but not the sharp declines that preceded it. Inflation has mostly hovered at or below 2% for the past 10 years. We think the current inflation spike will prove to be transitory rather than the beginning of a higher inflation regime.


Inflation recently surpassed 4%, but for how long?

Vaccine rollouts and unprecedented federal fiscal stimulus have created some of the strongest economic growth data in decades. The U.S. will likely witness a marked acceleration in inflation during 2021 due to base effects and supply chain stress as the economy reopens. Across all markets, supply chain blockages, coupled with sharply higher demand from a post-pandemic economic bounce, could lead to temporary price shocks.

But this large one-time boost to demand will fade as supply catches up. At the same time, the U.S. Federal Reserve has pledged to keep monetary policy accommodative until unemployment falls further and inflation materializes above its 2% target.

Persistently high wage growth, a symptom of a tight labor market, would signal that higher inflation might soon be on the way. With unemployment close to 6% and millions yet to return to the labor force, we don’t see significantly higher inflation happening in the near term.

High-frequency indicators reflect a reopening economy
The employment gap will take time to recover

But what if we’re wrong? Diversification is the key. Portfolio assets should be selected to perform well not only in our expected scenario of modestly higher inflation, but also during bouts of deflationary and inflationary pressures. Thus, investors should consider allocating a portion of their portfolios to inflation-sensitive assets that can withstand moderately higher price pressures.

[Interested in learning more about inflation-sensitive assets? Download now to read more.]

Are we returning to the 1970s?

Rapid inflation occurs when demand rises quickly and supply cannot catch up, and preventing this mismatch is the primary job of central banks.

In the early 1970s, the Federal Reserve misjudged how loose it could run monetary policy at a time of large budget deficits, wage and price controls and the U.S. dollar’s recent departure from the gold standard. Unemployment fell, but prices rose in uncontrolled fashion. Consumer price inflation averaged just over 7% for the decade. This eventually forced the Fed to aggressively raise interest rates, which succeeded in bringing down inflation but also caused two painful recessions.

The elements are different this time around. The world’s largest economies are still running well below their full capacity.

How do investors guard against inflation risk?

Inflation risk can be difficult to quantify. We have not seen persistently high inflation during the modern Fed era of quantitative easing, forward guidance and anchored inflation expectations. For that reason, correlations must be calculated over longer time periods.

It’s also important to distinguish between investors’ inflation expectations (and, related, what these expectations may mean for shifts in central bank policies), and actual inflation surprises shown in economic readings. Recent reflation has been driven by rising inflation expectations from a low level, reflecting investor optimism around economic growth, as well as eventual prospects for a less accommodative policy environment. This trend has been positive for most risk assets, but less so for rate-sensitive fixed income.

Inflation surprises, in contrast, come when realized inflation does not match expectations. As such, emphasizing assets correlated to inflation surprises might help a portfolio better withstand inflation-induced market volatility.

For income investors, inflation protection must be weighed vs. a) the yield of a given asset class and b) the broad volatility introduced into the portfolio. Why are inflation-sensitive income producing assets important in a portfolio? They can provide the dual benefit of generating solid real returns and provide broader diversification.

Asset classes have different sensitivities to inflation

Investment ideas: preparing portfolios to guard against inflation risks


Focus on credit risk within fixed income, rather than taking on duration risk.

 

Rotate toward areas of the equity market that benefit from reflation.

 

Increase allocations to real assets, including real estate and infrastructure. 

 

Consider how asset classes work together and be prepared for different risks.

 

Bond market correlation with equities approaches zero, with Treasuries remaining negative

Investors must take on different risks

We expect inflation to climb modestly over the next couple of years. Over the longer-term, inflation will likely fluctuate depending on cyclical conditions. Future recessions will put downward pressure on inflation, but investors may need to prepare themselves for a inflation environment higher than the sub-2% level that has been in place for so long.

While we don’t expect these shifts to have major immediate implications for portfolio construction, it is important for investors to take on different risks. These include focusing on increasing credit and real assets while also considering less liquid assets to improve a portfolio’s volatility profile. Most importantly, investors should remain flexible and focus on in-depth research, as careful planning is necessary to address shifting dynamics.

Related articles
Weekly Fixed Income Commentary Treasury yields rise slightly as economic data strengthen
U.S. Treasury yields rose slightly last week on strong economic data, even as inflation moderated more than expected.
Income Investing A risk-based approach to building portfolios
Nuveen’s risk-first approach to multi-asset portfolio construction introduces new asset classes and more complexity, but this also increases the opportunity to build more diversified portfolios.
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Endnotes

This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy, sell or hold a security or an investment strategy, and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions should be made based on an investor’s objectives and circumstances and in consultation with his or her financial professionals.

The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results. Investing involves risk; principal loss is possible.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. For term definitions and index descriptions, please access the glossary on nuveen.com. Please note, it is not possible to invest directly in an index.

A word on risk

Equity investments are subject to market risk, active management risk, and growth stock risk; dividends are not guaranteed. Foreign investments involve additional risks, including currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. These risks are magnified in emerging markets. The use of derivatives involves additional risk and transaction costs.

Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, tax risk, political and economic risk, derivatives risk, income risk, and other investment company risk. As interest rates rise, bond prices fall. Credit risk refers to an issuer’s ability to make interest payments when due. Below investment grade or high yield debt securities are subject to liquidity risk and heightened credit risk. Foreign investments involve additional risks as noted above.

Socially responsible investments are subject to social criteria risk, namely the risk that because social criteria exclude securities of certain issuers for non-financial reasons, investors may forgo some market opportunities available to those that don’t use these criteria. Investors should be aware that alternative investments including private equity and private debt are speculative, subject to substantial risks including the risks associated with limited liquidity, the use of leverage, short sales and concentrated investments and may involve complex tax structures and investment strategies.

Nuveen provides investment advisory services through its investment specialists.

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