PIMCO recently released a commentary on their inflation outlook and how to handle it in a portfolio. The comments of Mihir Worah, the head of PIMCO’s Real Return portfolio management team, were, I thought, exceptionally clear and direct. A glance at PIMCO’s resume as the largest global bond manager might also suggest you take their viewpoint seriously (or cause heart palpitations, depending on your portfolio allocation). Here’s their summary:
- We expect popular measures of inflation to show modest increases in price levels this year from last year.
- Masked behind these seemingly benign near-term increases in inflation are a number of longer-term factors that we believe could actually result in undesirably high rates of inflation in the not-too-distant future.
- Higher rates of increases in food, energy and other commodity prices are leading to a divergence between the core rate of inflation that the Fed focuses on and the headline rate that includes food and energy prices and actually affects consumers.
That’s a pretty calm way of saying 1) inflation is going up, especially if you eat or drive, and 2) it could get out of control.
The article discusses some of the causes, which include increased demand for commodities in emerging markets, overseas wage increases that may increase import prices, and problematic domestic monetary and fiscal policy. Mr. Worah points out that large components in the CPI, like rents, appear to have stablized and will no longer be offsetting increases in some of the other areas. Commodity prices especially were emphasized as a problem:
We feel that although commodity prices may show tendencies to revert to a “mean,” the mean itself is not static, but rather a moving and, in our opinion, a rising target.
The most stark conclusion comes after the discussion of domestic fiscal policy:
Our budget deficit is around 10% of GDP and given the current trajectory and in the absence of a surprise economic expansion or political compromise, we estimate our debt-to-GDP ratio will reach around 100% in a few years. There are three ways to solve our debt problem: Growth, Inflation or Default. The choice is clear to us; which one seems most likely to you?
This is an excellent rhetorical question! Realistically, it seems that intentional inflation is a more palatable political option than default. Growth is really a non-option in my view, since the historical track record of governments is that they have always spent all receipts, plus a little more for good measure. Growth will help but seems unlikely to bail us out in the long run. Ken Rogoff points out that defaults often occur when debt is owned externally, but when much of the debt is owned domestically, inflation is a more typical outcome.
In archly understated fashion, PIMCO suggests:
All things considered, investors may wish to consider adding assets typically associated with inflation-hedging strategies to their portfolios.
While this may be bad news to the legions of retail investors snuggling up with their recently purchased bond portfolios, it may not be the end of the world for investors committed to global asset class rotation. (The types of asset classes than PIMCO suggests may be useful for inflation-hedging—commodities, real estate, equities, foreign bonds, and TIPs—are all, not coincidentally, included in the investment universe for our Global Macro strategy.) Tactical asset allocation makes a great deal of sense for inflation hedging, since many of the asset classes in question are quite volatile and may not be desirable to hold for the long term in the context of a strategic asset allocation.
