Systematic Relative Strength

Inflation can be quite insidious. It can rob you of your purchasing power, even as your account balance continues to climb. Inflation is the perfect crime. Like all the best crimes, you don’t even know it has occurred. You are pickpocketed without ever noticing, until eventually it dawns on you that your wallet is missing.

Right now, economists are still debating whether we have or will have inflation or not. American Century Investments recently put out an excellent report that has a useful way of thinking about this debate, along with some suggestions on how to deal with inflation in your portfolio. Much of the debate seems to be semantic, but it makes a lot more sense if you categorize the discussion:

1. Backward-looking signals, which tell us more about where we’ve been than where we’re going.

2. Forward-looking signals, which are based on financial market expectations.

In terms of backward-looking signals like reported prices and price indexes, things are looking pretty rosy. Inflation is not a problem. The forward-looking signals are all market-based, like bond prices and bond spreads. And here, the view is a lot less rosy:

These signals, unlike past price trends, are not mixed—they unanimously indicate that possibly higher inflation appears to be a risk in our future, reflecting the present point of view and concerns of the bond market. Bond traders try to anticipate future economic conditions and the risks that result. Right now, they’re seeing the stimulative monetary and fiscal policies that the Fed and U.S. government are executing, and projecting their impact on the U.S. dollar, budget deficits, debt levels, the money supply, and consumer demand.

To the bond market, these policies appear to be inflationary, resulting from a weaker dollar, rising budget deficits and debt levels, money supply growth, and increased consumer demand. So bond traders are holding out for lower longer-term government bond prices and demanding higher long-term bond yields to compensate for the inflation risks they see down the road, even as short-term yields remain relatively low (because of Fed policy—see below). This wide difference between short- and long-term Treasury yields (a “steep yield curve”) can be viewed as a harbinger of future inflation, as can increasing Treasury breakeven rates.

Markets, as we’ve written many times, don’t trade on reality—they trade on expectations. Just because the market is expecting inflation doesn’t mean that it is going to happen. Still, if the market happens to be right, it makes sense to have some inflation protection. (I think the current score in this contest is something like Market 116, Economists 1.) Here’s what American Century recommends for the purpose of inflation protection:

• TIPS and other inflation-linked securities
• International bonds and other non-dollar investments (non-dollar-denominated investments can perform well for U.S. investors when the U.S. dollar declines)
• Commodities and/or commodity-related securities
• Precious metals and/or precious metal-related securities
• Real estate and/or real estate-related securities

Right about now you are probably scratching your head, wondering why everything on this list is on the list of eligible securities for the Global Macro strategy. It’s not a coincidence. The Global Macro strategy was designed to adapt to a lot of different economic and investing environments, inflation being one of them. If we get inflation, many of these instruments will gain relative strength and will get pushed into the portfolio. Some of them are already there.

Relative strength and tactical asset allocation is a useful way to handle a multi-asset portfolio. Don’t forecast, and just see where relative strength takes you.

Trying to estimate future returns, standard deviations, and correlations for commodities, precious metals, and other volatile asset classes to construct an efficient portfolio from a mean variance optimzation point of view is going to be pretty much impossible, so Modern Portfolio Theory isn’t going to be much help. Simply plugging in past returns might not help either, since most of the data corresponds to the 30-year cycle of disinflation we’ve just been through.

Once inflation gets started in the global economy, it’s not easy to stop without killing the patient. Whether you use the Global Macro strategy as a separate account or in mutual fund form (DWTFX), or any of the competing commodity funds or rotation strategies is up to you-but you should give some serious thought to how you are going to protect your clients from a thief they cannot see.