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Inflation Protection Beyond TIPS

Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. We're talking about inflation on the site all this week, and I'm joined today by Marta Norton. She is an Investment Manager for Morningstar Investment Services, and her group has done a lot of research in how to protect a portfolio from inflation.

Marta, thanks for being here.

Marta Norton: Happy to be here, Christine.

Benz: So, I think people naturally think of TIPS as a good starting point for protecting a portfolio from inflation, but you believe that inflation protection doesn't start and stop with TIPS. What else should be part of a person's portfolio looking for inflation protection?

Norton: That's right. So, I think investors have go-to asset classes when they think of inflation protection, and TIPS is obviously one, since they're Treasury bonds that are adjusted for changes in the consumer price index. And commodities are another, which makes sense as they themselves are a source of inflation, and then you also have real estate, which is commonly brought up when people think of an inflation protection.

Benz: How good an inflation hedge is real estate? I'm curious about what your research shows?

Norton: Our research suggests that it can be an effective hedge, but there are also factors that can reduce its effectiveness. When you think of REITs, real estate investment trusts, they're collecting the rents from apartments or commercial properties in general. Often, those rents can tick up during inflation periods. So that's the value to them.

But at the same time, high vacancy rates or valuations can reduce the effectiveness of that hedge. So, we haven't found it to be a top contributor to inflation protection, but it's certainly something that I think investors traditionally look to, and it's something that I think can add value, but just at a smaller margin than maybe people assume.

Benz: Would that be global, would you say? A global real estate portfolio versus one that's domestic only?

Norton: We think globally at Morningstar Investment Services, and I think global is the way to go, especially if you're concerned about U.S. inflation. You can get diversification by broadening your portfolio.

Benz: Okay. So TIPS, real estate, commodities, are those baseline inflation protection exposures. What are some other things that maybe are a little off the beaten path that you think people should be thinking about?

Norton: Right, so when we run correlation figures across a wide variety of asset classes, we find a number of asset classes that kind of pop up as impressively related to the consumer price index movements, probably even more so than TIPS in certain periods.

Benz: So do tell.

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Norton: Bank loans are one, and I think people are somewhat familiar with these securities, where their coupon payments adjust for changes in the short-term interest rates, and that can be very effective in inflation periods simply because interest rates start to tick up.

There are other areas, high-yield bonds, they have these fatter coupon payments, so they're less affected by inflation and interest rates. And actually when you think about both bank loans and high-yield bonds, both of those asset classes can experience fundamental improvement during inflation periods, because the value of the outstanding debt shrinks as inflation picks up.

So, asset classes that can experience fundamental improvement--unlike other asset classes that actually suffer--in inflation periods makes these attractive. I think convertible bonds fall in that same subset for similar reasons.

But outside of that, when you think of inflation protection, I don't think you should just be worried about inflation, because there are other risks that go along, or hands-in-hand, with inflation, like rising interest rates or the dollar getting hurt.

So, when we think of inflation protection, we actually think globally, not just in real estate, but also in global stocks and global bonds, emerging-market currency--ways to kind of loosen a portfolio's ties to the greenback.

I think when you think about global stocks, you shouldn't just think about global stocks generally, because not all stocks are created equally, but you want to think about companies and industries that really have pricing power, and can pass along higher input prices to their consumers. That's a good bet for investors.

Benz: What we often call the wide moat companies with the sustainable competitive advantages.

So, I want to back up, Marta, and talk about the fact that a lot of these things we've been talking about--banks loans and high yield, in particular--are looking maybe a little richly valued currently, or certainly not as cheap as they were a few years ago. So I guess a question is for people looking at these asset classes, do they want to try to be tactical about them? Is it wise to load up on them when they're looking cheap and maybe pull back a little bit when they're relatively more expensive?

Norton: I think when you think about tactical, you have to think about it in two different ways. One is tactical as in going all-in and all-out, and the second is being underweight and overweight. And we'd favor the second approach over the first approach, because when you think of inflation protection, it really is a form of insurance, and just like I would think most people wouldn't try to be tactical with their flood insurance, you know, buying in at just the right time, because it would be very expensive and hard to get, we wouldn't think you would want to buy inflation protection at just the right time. I don't think it's an easy call for anyone to make--timing inflation--and you also might find yourself paying through the nose once it's at the threshold.

So I think if you're worried about inflation protection, say you're a retiree who is getting close to tapping into his assets, maybe that's a time to layer an inflation protection and leave it there, but you can still be tactical in the sense that, TIPS with their miserable low real yields--is that an asset class that you would want to be overweight or even neutrally weighted at this point in the game? In our view, we would back away from TIPS. We'd still have it in our portfolio, but we wouldn't be all-in, so to speak. ... There is a big difference between being underweight and completely absent altogether.

Benz: So I also want to talk about commodities. Maybe four or five years ago, there was a big vogue for recommending commodities, futures-based commodity strategies, for many investors. Now, I'm sensing that a lot of advisors and a lot of professional money managers are kind of backing away and saying, "Well, the contango and other issues that affect the commodity-based strategies are pretty bad. Maybe we want to look at a pure natural-resources stock fund instead." Where do you come down on that question?

Norton: I think there are trade-offs in both camps. So when you look at commodities, there are really three sources of return: The spot price, the interest you're getting on your collateral, and then also that roll yield, which is affected by contango. So the idea of contango meaning that you're selling the cheaper contract and buying tomorrow's more expensive contract, and that's never ... the investment philosophy would argue against doing that. So that's certainly something that can be negative in the short run or in certain market environments for commodity futures.

At the same time, when you look at natural-resource stocks, these are companies that are in the business of the commodities, and they can make money and capitalize on the commodities, but you're also getting that equity market exposure, and you might make some bad stock picks.

So we would argue that commodities have a role, and we would use commodity future funds for that stake. At the same time, we would add natural-resource stocks to the portfolio, and that would require us trimming that commodity stake in the futures funds and trimming global stocks and kind of treating them as a hybrid between those two asset classes.

Benz: Okay. So, I want to talk about the global piece and why global is such a part of the way that you think about this. Is it that if we experience inflation, it will really be a global phenomenon rather than one that is experienced just here in the U.S.? What's your take on that question?

Norton: I think it can go both ways. I think you can see global inflation, and I think inflation in some countries can affect or cause inflation in another. Certainly some people are arguing that we can import inflation from China as we buy their goods and services, and they're higher priced.

So, I think inflation can affect across borders in that regard, but ... I guess in thinking globally, at Morningstar Investment Services, we think it's a mistake to just narrow your universe just to the U.S. I think you just lose investment opportunities in that regard, and I think currency is a big driver of returns. So any time you can have some diversification in that regard, you can kind of spread your portfolio a little bit better.

Benz: Okay. Well, Marta, thank you so much for sharing your insights on this really important question. I appreciate you being here.

Norton: Absolutely, my pleasure.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

Marta Norton
Investment Manager
Morningstar Investment Services

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