Inflation is back and it is a risk that should be managed. But rather than using historic CPI data, investors can apply quantitative techniques to develop a forward-looking view on inflation risk in equities, Allspring Global Investments says.
For much of recent history, inflation has not proven to be much of a risk to investment portfolios.
The previous period of high inflation occurred roughly from the mid-sixties until the mid-eighties, when inflation in Australia peaked at 17.7 per cent.
But since then, inflation has remained mostly below 4 per cent.
The risk to investment portfolios was so benign that most current off-the-shelf risk models did not include it in their toolkit anymore.
But today we are in a very different inflationary environment.
Australian Bureau of Statistics data shows that since the beginning of the year the consumer price index (CPI) has hovered just below 7 per cent, a far cry from the Reserve Bank of Australia’s target bandwidth of 2 to 3 per cent.
Since 2015, 2016, the inflation sensitivity has started to pick up, but because we've been in such a low inflation environment for so long, people still haven't paid much attention to it
Looking at the elevated levels of inflation, Harindra De Silva, a portfolio manager for the Systematic Edge team at Allspring Global Investments, asked whether he and his team could develop a quantitative way to assess inflation risk and build equity portfolios that are largely insulated against this risk.
“Inflation hasn’t been considered for a very long time period and it is only recently that it has actually started to be considered important again,” De Silva says in an interview with [i3] Insights.
“Yes, prior to the GFC, you saw relatively high inflation sensitivities, but then starting in 2008 they just kind of fell away.
“However, since 2015, 2016, the inflation sensitivity has started to pick up, but because we’ve been in such a low inflation environment for so long, people still haven’t paid much attention to it.
“But this is a risk exposure that you should manage or at the very least should measure. Then a third order version would be to take an active tilt based on [inflation risk].”
Learnings from History
To assess inflation risk in equity portfolios, De Silva and his team have developed a method that looks at inflation as a factor, using changes in the valuation of one-year inflation swaps as their guide.
“The inflation swap is forward looking and the correlation between the forward-looking measure of inflation and the subsequent reported year-on-year realised CPI number is quite high,” he says.
This idea of using inflation as a factor finds its origin in a study from 1986, when Nai-Fu Chen, Richard Roll and Stephen A Ross published a paper, “Economic Forces and the Stock Market”.
This paper explored the idea of building portfolios that were insulated from inflation shocks. But back then the only data available was the CPI. The problem with using the CPI is that there is a substantial lag in the reported data and current developments in the economy.
The actual inflation data only comes out with a substantial lag, but the nice thing about the swap is that it is priced daily. It is really more of a now-casting idea
“The actual inflation data only comes out with a substantial lag, but the nice thing about the swap is that it is priced daily. It is really more of a now-casting idea,” De Silva says.
He gives the example of the invasion of Ukraine by Russia and the subsequent spike in grain and energy prices.
“When the Ukraine crisis broke out, inflation expectations went much higher because of the grain issue. Ukraine provided most of the grain to Europe and then you also had the energy issue,” he says.
Swap prices responded accordingly.
“There was a quick response that you could actually see in the swap, while the CPI number wasn’t going to catch up for a long time after that,” De Silva says.
Inflation and Equities
Traditionally, investors have looked at inflation-linked bonds and real assets for inflation protection, but shifting allocations to these assets often comes at the price of lower returns.
Equities are more sensitive to inflation, but also tend to reflect inflated prices much quicker than other assets as businesses pass on prices to consumers. Therefore, holding an equity portfolio that is inflation risk aware could form a good addition to multi-asset portfolios, De Silva says.
Using the factor approach to inflation allows him to build equity portfolios with a real return objective that are relatively insulated from inflation shocks.
“When investors think about inflation, their first response is TIPS (Treasury Inflation Protected Securities), gold or real estate, and those are the obvious places to look,” De Silva says.
“But you will probably have this trade-off where if you buy an asset that is inflation hedged, you will have to accept the lower expected return. The key with equities is that the earnings are going to grow faster with rising inflation, which you don’t have with gold and TIPS.”
He says applying a quantitative approach offers a more accurate way to adjust for inflation expectations than taking a high-level sector approach.
“Yes, sometimes you can try and do this using heuristics and say energy companies are not that sensitive to inflation or that utilities have negative sensitivities, but when you do it quantitatively you actually get to see a clear picture,” he says.
He also points out that using forward-looking swaps allows investors to take a much more active approach than simply relying on historical patterns.
“This is truly active quant, because traditional quant was always looking at historical patterns and hoping they would repeat. But this is a great example of how the world is clearly different now,” he says.
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