Retirement insights from a Colorado PERA perspective

Issues & Perspectives

Real-Return Investments for Inflation Protection

institutional investors

The U.S. economy is humming along, despite international trade tensions and a relatively flat Treasury yield curve. As economic growth continues amid uncertainty, investors could be looking to diversify their portfolios and protect against potential inflation.

Inflation Amid Economic Uncertainty

At its annual symposium in Jackson Hole, Wyoming, on August 24, 2018, Federal Reserve (Fed) Chairman Jerome Powell indicated the central bank expects U.S. economic growth to continue at a pace at which gradual interest rate hikes would remain appropriate. While the central bank does not foresee a surge in inflation beyond current levels, Powell also pledged the Fed would adjust monetary policy responses as needed should the pace of inflation threaten economic stability.

The ambivalent tone the Fed set in August has not been clarified by a definitive market outlook over the past few months. The U.S. dollar has been strong enough to keep prices from ballooning, but could fall in the face of trade tensions, thereby escalating inflation. The bond market anticipates economic slowing, while the stock market has reached, and wavered at, all-time highs. Concurrently, the labor market is expected to remain strong, reflecting greater expansion.

On September 18, 10-year Treasury yields broke higher than 3 percent for the first time since May. Despite that boost, the yield curve remains near its flattest levels in over a decade — a signal that bond investors are not so optimistic about the macroeconomic outlook. Concerns of a potential economic downturn are stoked by expectations of the Fed raising rates by another 0.25 percent in 2018. That move could tighten, and potentially invert, the yield curve by lifting 2-year yields near or above current 10-year yields. Inverted yield curves have historically preceded recessions.

Meanwhile, there are signs the economy is on a path of increased inflation. Recent economic data show labor wages are rising, unemployment is at 49-year lows, and consumer confidence is at 18-year highs. With growing consumer confidence, some companies have indicated plans to increase prices on their core products to spur profits while covering the rising costs of raw materials. These are markers of economic growth and contributing factors to higher inflation, which fueled the Fed to raise interest rates on September 26.

The question remains how much further the economy can expand, and how quickly. All eyes are now on the December Federal Open Market Committee (FOMC) meeting, when the Fed is expected to raise its funds rate for the fourth time this year. Hiking interest rates by a quarter of a percentage point would maintain the central bank’s course of slow and steady response to sustained growth. If inflation increases more rapidly, the Fed may respond in kind with steeper or more frequent rate hikes. Conversely, if inflation cools, the Fed may respond with fewer rate hikes. For now, analysts are predicting the Fed will hike rates two to four times through 2019 in an effort to temper inflation.

Investment Diversification for Hedging Against Inflation

The impacts of inflation – reduced purchasing power of each dollar and resulting consumer price sensitivity – are further amplified in an economic environment underpinned by macroeconomic uncertainties such as international conflict or trade disputes.

So how can investors find protection from inflation? A diversified portfolio is an essential foundation for hedging against volatility in markets, and some instruments may be particularly beneficial to a portfolio in an inflationary environment.

Treasury Inflation Protection Securities, or TIPS, are government-issued bonds that guarantee a return above the inflation rate. TIPS pay a fixed interest rate semi-annually on a fluctuating principal amount that is adjusted with inflation as measured by changes in the Consumer Price Index. As inflation increases, the bondholder is paid the fixed interest rate on an increasing principal. In the case of deflation, the bondholder is paid the fixed interest rate on a decreasing principal, but with the safeguard of the security’s original principal being the minimum payout at maturity. TIPS can offer investors an interest income stream and tax benefits with capital preservation while contributing to a portfolio’s defensive capacity in volatile and inflationary environments.

Private real estate investments can strengthen in periods of economic growth, and may offer opportunity for rental income. Real Estate Investment Trusts (REITs) are another option for investors looking for real estate exposure without the large capital commitments or liquidity risks of direct real estate investments. REITs offer publicly traded shares of companies that own commercial real estate such as hotels, apartments, hospitals, offices and warehouses. Many REITs offer competitive dividends that can outpace inflation to secure a steady flow of returns.

Commodities encompass a broad range of raw materials and agricultural products, and their values usually increase with inflation as rising demand increases the price of commodities used to produce goods and services. While shocks in supply and demand may increase the price volatility of consumable commodities, such as oil and coffee, precious metals such as gold can offer investors relative stability, while still hedging against inflation. Gold has demonstrated an indirect correlation to the value of the U.S. dollar, often rising when the dollar falls, offering additional inflation protection. Commodities that have low correlation with cash or other equities can provide great diversification benefits during market turmoil. Furthermore, investors can access commodities markets through financial derivative instruments, such as futures contracts, eliminating the burden of holding physical assets.

Traditional natural resource equity investments include those in natural resource management industries such as mining, energy production, and agriculture. As global needs and technologies evolve, differentiated resource investments in clean and renewable technologies have emerged. When demand for infrastructure, repair and commodities rise, so do the prices of resources and the costs of their production. The correlation of natural resource equities with commodities can offer insights into economic trends while providing returns that keep pace with growth rather than being diminished by inflation.

TIPS, REITS, commodities and natural resource equities are examples of assets investors might choose over holding cash in order to hedge against inflation and diversify a portfolio. Some funds offer exposure to these assets through mutual funds or 401(k) savings plans which can give options for inflation protection to individuals saving for retirement. Members of Colorado PERA who participate in its defined contribution plan, including the 401(k) and 457(b) plans, have the option of investing in the PERAdvantage Real Return Fund, which invests in the real return asset sub-classes mentioned in this article.

LiquidityThe ease with which an asset can be converted to cash without a significant loss of value.Defined contributionA type of individual retirement plan in which an employee saves a portion of each paycheck (along with a potential employer match) and invests that money. The employee’s retirement benefit is based on their account balance at retirement. A 401(k) is a type of defined contribution plan.VolatilityA state of unpredictable activity in financial markets, during which prices can experience significant and/or unexpected swings in either direction.

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