Howard Marks is chairman of Oaktree Capital, a large and well-known institutional alternative fixed income manager. Mr. Marks’s memos are always thoughtful and worth reading. This go round he has a discussion of all of the things that could go wrong with the world economy—essentially a list of all of the things that could go wrong. One of the things that could go wrong is inflation.
He believes rates are more likely to go higher than lower, and that inflation, long forgotten as a risk factor, might return. In addition, he has a list of suggestions on how to deal with inflation including TIPs, floating rate debt, gold, real assets like commodities, oil, and real estate, and foreign currencies. His catalog of alternatives is even longer, but you get the idea. (If you want to read the whole memo, you can find it here.)
That’s quite a list, but the first thing that I noticed about it is that not one of these items is generally considered as an investment option by retail investors. Most investors are mentally stuck in the domestic stocks/domestic bonds arena. Diversification consists of hitting more than one Morningstar style box. If inflation does come back, that’s not going to cut it. In fact, Mr. Marks asks investors, “How much of your portfolio are you willing to devote to protect against these macro forces?” He says if the answer is 5%, or 10%, or 15% that those levels are pretty close to doing nothing. He thinks a portfolio will need to devote at least 30-40% of assets toward inflation protection if it recurs.
Investment flexibility and risk diversification were the primary reasons that we launched the Systematic RS Global Macro account as a retail product last year. Many of the inflation hedges in Mr. Marks’ list are asset classes that are available in the Global Macro portfolio, including TIPs, gold, commodities, oil, real estate, and foreign currencies. Given our basket rotation strategy and our adherence to relative strength, the Global Macro portfolio could easily have 40% of its assets, or more, in inflation hedges if inflation were to recur. I think the jury is still out about how the world economy will respond to decreased levels of fiscal stimulus, but it’s good to know that you have options.
—-this article originally appeared 1/25/2010. We have not seen runaway inflation so far, but the point Howard Marks makes is valid. If/when inflation does occur, you might need to devote a lot of your portfolio to inflation protection. Is your investment process up for the challenge?