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Everything is transitory, even stubborn inflation
Views from the TIAA General Account
Many in the economic press are debating whether the recent bout of inflationary pressure has been wrongly described as transitory. But labeling something as transitory, doesn’t tell us much about how long it is likely to last, only that it won’t last forever. And that’s very relevant to how your investment strategy should approach the problem. Semantics aside, without doubt, higher inflation is currently creating challenges for retirement plan providers and institutional investors — and the participants we serve.
U.S. inflation reached 8.6% in May, levels not seen since the 1980s, and it’s hard to tell if we are at the peak. But when it does peak, we aren’t necessarily going to go back to the very low levels we’ve seen over the last decade or so for some time. But the question isn’t when will inflation peak, but rather what will the U.S. Federal Reserve and other central banks do to combat it, how will the economy react, and how can we address inflation risks in our portfolios?
Inflation vs. economic growth
I’m confident that central banks can bring down inflation eventually, but I’m not sure what it will cost to accomplish that. To tame inflation in the U.S., for example, the Fed needs to carefully manage an economic slowdown, which creates the potential for a recession. But while tasked with managing macroeconomic policy, the Fed is also trying to manage the market response to its policy actions.
We can see that in the most recent rate hike. The Fed had been signaling a 50 basis point rise, but then increased it to 75 bps in June, largely because that’s what the market was pricing in. Its efforts to manage inflation and employment now appear to be in the context of how the market will react should its policy diverge from market expectations.
One risk vs. many risks
With inflation and rates trending upward, the many-decade bond bull market run has reversed. This may tempt investors to manage inflation risk tactically. But we think that’s a strategy with a low probability of success. Rather, we believe the best approach to inflation risks (and all risks for that matter) is a long-term thematic approach.
When we establish our asset allocation, we focus on earning risk premiums that will compensate us for a variety of risks. This means we can’t just focus on inflation. For example, investing in floating rate loans with healthy credit spreads should more than compensate for rising inflation. But there are credit risks associated with this kind of investing as borrowers may struggle if the economy slows or worse goes into recession. Focusing on one risk – inflation – is likely to come at the expense of introducing or increasing other risks in the portfolio.
Short term vs. long term
Investors, whether individuals or institutions, should seek premiums that can generate enough return to retain purchasing power for the average level of inflation over the long term. Trying to hedge for inflationary spikes is usually a bad idea. You’ll be paying a lot when inflation is low, and trying to time the market is an impossible feat.
Maintaining that longer-term perspective makes you realize the transitory nature of most market conditions. It allows for a broader range of risks to be included in portfolio construction and also a broader range of investment solutions to deliver risk-adjusted returns. Additional risk factors, such as those that address environmental and social issues, often play out over the medium and long term as well. And some asset classes, notably real estate and other real assets, have long-term holding periods. Looking to these long-term assets can improve a portfolio’s overall risk-return profile and their cash flows could potentially provide a partial hedge against long-term inflation.
Focusing on inflation is likely to come at the expense of introducing or increasing other risks in the portfolio.
As part of his participation in Nuveen’s Global Investment Committee, Nick Liolis offers his perspective as an institutional investor and asset allocator. Neither Nick nor any other member of the TIAA General Account team are involved in portfolio management decisions for any third-party Nuveen strategies.
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